Twenty-Five Central Banks Easing, Lessons and Examples
“Like a full force gale, I was lifted up again”
—Van Morrison
What is a monetary tsunami?
The massive monetary stimulus created in the past decade is unprecedented.
The United States created more money between 2008 and 2016 than in its entire previous history,1 and China multiplied its money supply by four. Broad money as a percentage of GDP globally exploded 20 percent in this period.2
Many monetarists believe that all of this is nonsense because a large part of this money is “sequestered” as excess reserves in the financial system. It does not matter, because those reserves fuel the liquid financial asset bubble and the imbalances of banks.
I call the consequences a monetary tsunami because it is formed in a similar way. A series of waves in a water body caused by the displacement of a large volume of water. A series of financial crises generating a domino effect.
The monetary tsunami happens when a) part of the massive amount of money is unleashed into the economy and b) the massive liquidity that is created to abort a financial crisis does not create any mitigating effect.
When this happens, it will not matter if mainstream blames banks, or speculators—believe me, they will—or calls for even more aggressive monetary stimulus. Because all of it will happen. But the reader is interested in escaping from the inevitable consequences, not in finding an easy scapegoat.
Looking for a scapegoat is essential in out-of-control monetary policies. In the French Revolution, the authorities blamed shop owners for not willing to accept Assignats, the useless currency that flooded the country. In Venezuela, they blamed an economic war and even used an excuse that speculators were hoarding cash notes in Poland, forgetting that if that were the case, the currency would revalue, not devalue. In Spain, in 2008, the media and the government blamed hedge funds. There is always a scapegoat to justify the excesses of the past and deny its consequences.
The Biggest Risk: The Energy and Food Burden
What creates inflation is monetary policy at the end of the day.
—Robert Plosser3
The most important risk is that by trying desperately and with more aggressive measures to create inflation, you may succeed. Too much, too quickly, and negatively.
This would be my worst-case scenario: out-of-control inflation in commodities—food and energy—while core CPI remains subdued due to the slack in the economies, large debt, and overcapacity.
This scenario would lead quickly to a 2008-type crisis. Commodities would rise well above supply and demand logic, and the oil burden—the amount of GDP that the OECD consumes in crude—would exceed 10 percent. See Figure 9.1.
The oil burden, in my view, is a bad economic term more oriented to the old, heavily industrialized economies. Throughout the past decades, when OECD economies spent around 4 percent of GDP in oil, it was an almost certain risk of an imminent crisis. Families and industries would be unable to sustain the rising costs, loans in different sectors would be at risk, and the financial system would suffer a shock from nonperforming loans and slowdown of the energy-importing economies.
Figure 9.1 Oil burden and GDP impact
Source: World Bank.
This measure has always been used by debunked peak oil theorists to alert of the end of oil supply and the impending doom of depleting reserves, but it is simply a monetary effect. Too much money supply makes commodities—denominated and traded in dollars—rise when the U.S. currency is debased artificially.
It is not just the burden as a percentage of GDP that matters, but the severity and speed of the rise. Economies face enormous difficulties adapting to an environment where prices in foreign currency are rising faster than the ability to undertake emergency policies. This unexpected and abrupt burst of inflation does not translate into higher wages or more productivity; it just loads the economy with a rising cost that is not generating growth; it stagnates the economy.
The reader might think that this effect is only on the importing countries, but at the same time the producers thrive. And you would be right. And that is why I dislike the oil burden alone as a concept of rising risk and why I prefer the “energy and food burden.” Because, as we saw in past oil crises that had an unquestionable monetary origin, the producing countries witness an unprecedented rise in food prices. This leads to either a heavier burden of subsidies on the government or massive difficulties for the population, suffering from an inflation that is not covered by their meager wages.
We must consider this because it is quite typical that, when energy prices rise, media and consensus economists mention the positive effect on commodity-rich countries without understanding the impact of rising food prices. According to the World Bank, the average of household income spent on food is close to 35 to 40 percent in these countries.4 So, no, producers do not benefit from rising commodities as much as some think, particularly when such rise is quick and dramatic. The reader might think that all of this is fine but energy commodities can go up much more than food. Difficult. As a friend of mine always says, “We eat energy.” Many of the costs of energy commodities are embedded in food prices.
That is why I would use the “food and energy chain burden.” The amount of oil required for a unit of GDP, that is, the oil intensity of economies, has dropped dramatically in the past decades, and oil alone does not explain the risk of a shock. But a monetary policy-based rapid shock in energy and food commodities would be a much more precise measure of a coming financial crisis. It is safe to assume that when this “burden” surpasses 5 percent of world GDP we should be quite concerned.
How do a country and its citizens escape this shock?
First, using periods of low prices to invest in technology and substitutes. A country that is able to have a competitive and diversified primary energy use has a double advantage: lower cost of imports and higher flexibility. Investing in agriculture technology and improving productivity reduce the shocks of energy prices and secure supply, added to a balanced combination of genetically modified food and organic supply.
Producing countries need to increase investment in water management and agriculture technology and diversify their economies from commodities using the extraordinary revenues of boom periods to strengthen the economy for the next crisis, instead of wasteful spend in useless megalomaniac infrastructure projects.
Furthermore, periods of excess revenues should be used to reduce debt and avoid a sudden stop when cheap dollars stop arriving.
That was the difference between Saudi Arabia and Venezuela during the commodity boom. Saudi Arabia reduced debt from an average of 38.5 percent to an all-time low of 1.6 percent in 2014, which allowed the country to take large deficits to finance the expenditures of the government when oil prices collapsed. In the case of Venezuela, the country wasted more than $300 billion of extraordinary revenues and found itself with constantly diminishing foreign currency reserves and massive inflation when oil prices fell. Adding insult to injury, the policy of nationalizing thousands of companies left the country crippled with poorly run expropriated firms that ended bankrupt or with the lowest production levels in nearly a decade.
Additionally, taking measures to guarantee ample foreign exchange reserves and monitor excess borrowing in households and industries is critical. Recognizing that cycles become shorter and that the impact of a monetary and economic crisis will be felt for many years is an essential part of prudent governance. But admitting, after decades, that infrastructure spending must be adequately analyzed so that it does not become a weight on the economy’s potential growth is also essential.
Let us think of the consumer nations. Developed countries have a much better set of tools to respond to a commodity shock. But they also are ill-prepared for financial shocks that tend to follow them. Even more worrisome, developed nations are the first ones to fall in the trap of believing the exponential growth and the mirage of emerging market wealth even when it is coming from their own expansionary policies.
What happens is that most of the credit to finance the white elephants and excess spend of emerging markets is originated in developed nations. When a shock as the one described happens, capital in financial institutions falls dramatically. The impact on nonperforming loans affects credit to domestic companies and families as well; imbalances are generated by those same companies that believed in the mirage and overinvested in risky economies looking for growth and inflation.
Sometimes, Banks Do Well
This risk was adequately contained in the high-yield energy crisis in 2014 and 2015.
Energy companies had seen unprecedented access to debt markets throughout the boom in commodities created by the Federal Reserve and could finance capex and growth with cheap funding. In 2005 energy was around 4.5 percent of the high-yield market, that is, the bonds with higher risk and higher returns. By 2014, energy had risen to 15 percent.5
Despite some media and consensus commentators calling for an equivalent of the housing bubble, it did not happen.
Banks were very worried about the rising risk in energy many years before the peak in high-yield bonds. As such, syndications, by which banks reduce risk sharing it with many others, were the norm. Furthermore, unlike housing before the crisis, these asset-backed loans were also supported by a healthy level of mergers and acquisition transactions that ensured a minimum valuation existed. These loans were not worth zero.
Of the total high-yield debt of the United States, less than 15 percent was in energy and that included solar investments. Of the total investment-grade debt, less than 10 percent was in energy—including electricity. The fact that more than 89 percent of the country’s production was in large companies with little debt ensured that any crisis would trigger an asset transaction boom from predators’ bargain hunting.
Therefore, even if the market could consider that 25 percent of that debt was “unpayable,” the impact on the economy and the sector would be very small.
Deutsche Bank showed in a 2016 report (Should the Fed worry about the energy sector?) that the rate of default had not exceeded 5 percent. It was between 9 and 14 percent from 2008 to 2009.
Of the 120 companies that concentrated 95 percent of U.S. oil production, 97 have less than 1.6x debt over EBITDA6 and 79, less than 0.6x. More than $90 billion capital increases had been implemented. Despite the rise in risk, it was nothing like the housing bubble.
This fear of repeating a similar concentration of risk led to a completely different outcome. Yes, many small inefficient energy companies defaulted, and the spread at which the riskier names borrowed relative to investment grade soared ... but the domino effect created by the subprime crisis did not result in a financial and economic collapse.
Lesson learned? Not really. A lot of these risks were simply disguised by the increased excess liquidity generated by central banks. But the period from 2014 to 2016 showed to us that despite the many challenges in emerging markets, energy, and European banks, none of those events resulted in a massive financial crisis.
The Impressive Example of the Russian Central Bank
Twenty-five central banks in the world undertook aggressive measures to boost growth. The main tools, obviously, were to lower interest rates and devalue. The result, even more obviously, was that growth did not improve and financial repression simply weakened consumption and debt repayment ability.
It is called beggar-thy-neighbor policy because the idea is to devalue the currency, boost competitiveness, and increase exports, and all of it at the expense of the country to which we intend to sell our goods and services. What a great idea. To profit from our trading partners by creating massive imbalances in our economy.
Devaluation, as we said, is nothing but a hidden subsidy to crony sectors at the expense of savers. But sometimes devaluation is simply the process of reckoning of a previous exuberance in the currency and an excess that comes to an end.
There is one central bank in the world that refused to sugarcoat the economy’s imbalances with monetary laughing gas. Russia, of all places.
The governor, Elvira Nabiullina, did not fall in the trap of lowering interest rates and printing money to try to boost investment no matter what. Her policies were to closely monitor perverse incentives, penalize banks for not dealing with nonperforming loans, make very mild adjustments to interest rates, and allow the economy to adapt to a lower oil price and different macroeconomic environment without inflating financial asset bubbles. Many market participants criticized her for implementing a “tough love” monetary policy that was completely against the trend of central banks all over Latin America and the OECD.
While others expanded their balance sheet dramatically,7 buying sovereign and asset-backed securities, the Russian central bank’s assets were adding precious metals and deposits, and the size of the balance sheet was a fraction, relative to GDP, of that of any of the OECD counterparts. Rates remained high and liquidity contained, placing the policy of maintaining strong foreign currency reserves and gold at the forefront, relative to defending financial asset valuations. The vast majority of the Russian budget is in rubles. This allowed the country to reduce debt and maintain its spending in local terms—despite a devaluation that came from lower oil prices and external sanctions—and a level of inflation that the central bank recognized as part of the fundamentals of the economy and that was adequately covered by wages.
And Nabiullina was right. Monetary policy did not become a conduit for excess leverage and massive asset bubbles. Yes, markets dropped, and the government spending was contained in real terms. But the economy strengthened because it was better prepared for the difficult period by not denying reality, and by the time oil prices—the most important source of export revenues for the country—and sanctions were to be lifted, the economy would be much healthier.
In an interview, she explained:8
The first thing we see is that the key limiting factor for investment is not so much our high rate and tough monetary policy but rather structural limitations, the state of the investment climate and so on and so forth. Therefore, we believe that through our rate decision we will not be reducing economic growth and that the problems of economic growth have their root in structural limitations. In addition, our country’s economy will have to learn to live with a background of a really positive interest rate. This means that we will need investment into the improvement of labor productivity, we will need to improve efficiency and reduce costs, and this is precisely the kind of signal that our monetary policy is sending to the market.
By 2016, when oil prices had stabilized and the imbalances of the Russian economy had been largely contained, the governor of the central bank could be very proud to be one of the very few commodity producers that did not damage the long-term growth potential of the economy by betting on monetary policy to disguise reality or promote taking massive amounts of debt that would result in a burden for future generations.
Thanks to the Russian central bank’s policy, the country did not have to increase tax rates—Russia is one of the most attractive tax regimes in the world, with a low flat tax—to pay for the excess of debt that would have been accumulated by the government if it had followed the “example” of other central banks. Thanks to this “tough love” policy and a very tight and inflexible leash on risky lending, the country did not have to bail out overleveraged financial entities.
The reality is that Elvira Nabiullina and her team followed an almost Austrian approach to monetary policy: Recognize that cycles exist. She did not try to fool markets or the government by thinking that lowering rates and exploding liquidity would boost investment, because she made an absolutely spot-on analysis of structural strengths and challenges. Her goal was not to boost GDP artificially or fool anyone with the “wealth effect” by inflating asset prices. Her goal was to help the economy endure the pain of a recessive cycle without harming the economy further. And she succeeded. To me, the policy of the Russian central bank during the sudden stop in emerging markets was exemplary of what needs to be done to come out of a difficult period stronger and equipped with plenty of policy tools to manage any forthcoming challenge.
The lessons that emerging and developed economies could learn from the Russian central bank are plenty: Do not deny cycles, avoid science fiction guidance, implement a policy that recognizes the structural issues without trying to disguise them and, most of all, reject leaving a massive burden of debt and financial bubbles to future generations just to perpetuate the mistakes of the past.
Bravo, Elvira. Not many Keynesian consensus economists and bankers will recognize your excellent analysis and policies, but your country and its citizens clearly feel stronger.
The Russian was one that did not fall in the Central Bank Trap.
1 St. Louis adjusted monetary base: US$874.82 billion by 2008. Multiplied to US$3,418.37 billion by January 2017.
2 World Bank data.
3 March 25, 2011.
4 http://wsm.wsu.edu/researcher/wsmaug11_billions.pdf
5 Source: Simmons.
6 Earnings Before Interest, Taxes, Depreciation, and Amortization.
7 A comparative analysis of developments in central bank balance sheet composition. Christiaan Pattipeilohy.
8 Friday, 23 Sep 2016, CNBC.