The Economic Consequences Of The QE Era

The Economic Consequences of the QE Era

This is the outline of a talk I recently gave on the dangers of ignoring the behavioural lessons from the QE Era as policy makers get ready for the inevitable next financial crisis. The great thing about financial crises is there will always be another one – no point panicking today when you’ll get to panic again tomorrow! 

Always happy to visit any clients and do a variation of this presentation: contact me for details.

Central Banks, Financial Regulators and Politicians acted swiftly and decisively to address the multiple crises of the 2008-2022 era. We saw unprecedented Bank Bailouts, massive Quantitative Easing programmes, Zero and even Negative Interest Rates, and later, enormous Covid Recovery Spending programmes. These policies were enacted with the very best of intentions; to mitigate and ease the extreme social costs and economic destruction that could have followed the reverberating Global Financial Crisis (“GFC”) that really began in 2007, and to ensure continuity following the global Covid Pandemic of 2020.

Now the world is “normalising”. Interest rates are back around pre-crisis levels in many Western economies. Yet it’s increasingly clear the global economy and the financial markets, are changed, changed utterly – and not necessarily for the better.

My thesis is simple; the instability and uncertainty evident in today’s markets are largely the consequential outcomes of distorted interest rates through the QE era. We need to understand these effects to avoid repeating the same mistakes again.

Extraordinary decisions were taken during the crisis years. While these decisions seemed wise at the time, with the benefit of hindsight they may now serve as warnings about the consequences of consequences. We don’t know where the next financial crisis will emerge, but there are plenty of hints. Much of the Complexity, the Co-Dependency of financial institutions, Debt Burdens, Speculation, Liquidity, Leverage, corporate and individual Motivations, Political Populism, and even the Geopolitical fault-lines dominating headlines and fears of Conflict, can be traced back to the effects of monetary distortion through the QE era.

All financial crises are different, but it is a widely held belief in market circles that central banks and regulators spend their time preparing to address the last financial crisis. As crashes and crises are a recurrent badge of honour for all successful, inventive and innovative capitalist economies, how will economists and the policy makers they advise, absorb the relevant lessons from the 16 years since the GFC, and more recently Covid? How do we ensure we don’t repeat the same kind of mistakes all over again?

Don’t watch crowds – understand individuals

The new Artificial Intelligences that so dominate the value discussion in stock markets will have already taught themselves that Economics is not a linear, predictable science. It is subjective, not objective. Consequential effects cannot be perfectly modelled and predicted by scientists in pristine white coats in pristine clean labs. Economics happens out there – in the dumb, unpredictable, and dirty reality of the modern world.

The reality is economic consequences are determined not by the actions of policy makers, but by how those affected by policy change react – by the unpredictability and variability of human behaviour. No matter how big or granular a sample, or how the models predict how a big-enough crowd will act – it’s what the individuals outside the mindset of the crowd are thinking that makes them the ones to watch.

In coming years, whole new branches and disciplines of economics will emerge, based around the unpredicted economic behaviours encountered since 2007 as a result of chronic monetary distortion. It will be fascinating to see what they conclude – and what can be incorporated into the firefighting of future crises.

Interest Rates and Greed

The most obvious consequence of the QE era is how ultra-low interest rates did not necessarily promote growth, but the pursuit of optimisation, greed and wealth. For all the talk of stakeholder society, the only real beneficiaries were the already wealthy.

When the first quantitative easing programmes were enacted after the collapse of Lehman Brothers, (even as everyone watched in horror as banks threatened to tumble like dominoes), the policy makers had many concerns. Although central banks pumping money into the economy by buying back government bonds would support and stabilise bond prices, it would also further increase government debt in the wake of the vast sums extended to rescue the banks, raising issues about debt sustainability. Learned economic professors were warning how pumping money into the economy through QE could only be inflationary – inflation, after all, is always a monetary phenomenon.

However, policy makers and the markets perceive things rather differently.

• Central banks thought they were saving the economy by pumping money into it –enabling banks and institutional lenders to lend cheap money to firms to build plant and infrastructure, invest in capacity, productivity and create jobs.
• Regulators were busily locking the stable door after the horse had bolted with new rules designed to constrain bank risk taking.
• Investment bankers and traders were more than happy to sell Central Banks their own national debt, pulling down bond yields (thus pushing up the price), and using that money to buy other financial assets, correctly calculating that if government bond prices were rising, then that would lift the value of all financial assets due to relative basis, creating a massive market rally/bubble because interest rates were too low.

The key point to note is how global stocks rallied so strongly since 2009 – despite rather dull and lacklustre economic growth. Did shares rally because of the extraordinary profitability, inventiveness and innovative skills of corporates, or because stocks looked cheap relative to expensive bonds and money was effectively free?

The fact the first quarter stock rally of 2024 was almost entirely driven by the gains of the Magnificent Seven Tech Stocks on expectations, hopes and dreams of how AI would propel their valuations even higher illustrates the issue. The Magnificent Seven now appears to be broken, under threat on multiple fronts as the respective firms struggle with the realities of competition, demand, innovation, and supply – real world issues which were easy to ignore when liquidity was free.

FOMO – The new gravity

Since 2009 the greatest single driving force of financial asset prices has been FOMO – Fear of Missing Out.   Back in the early 2010s the risk-free rate – the government bond yield – was deliberately slashed by the launch of QE programmes. The immediate consequence was to hit the price of all other financial assets via relative pricing. The expectation was lower rates would drive increased investments into the real economy – making debt, mortgages and consumer debt cheaper to fund consumption, and for corporates to invest.

The effect was to make all financial assets look cheap relative to the risk-free rate. FOMO then became a self-fulfilling prophesy – Tulips on the Super Strength Plant Food – because bond yields were too low, yield tourists had to take more risk, by buying and pushing up the price of higher risk corporate debt, and equities. And as more people perceived the upside, the greater that FOMO pressure upwards became. The myth seized the market mindset of how incredible apparent wealth was easily achievable by investing in financial assets as ultra low interest rates pushed markets higher.

Yet, markets are all about narratives. The more believable a narrative is – the more likely it is to attract investors. Thus well-told fairy-tales and FOMO fuelled an era of fervid speculation – wildly ridiculous concepts such as Non-Fungible-Tokens, land in the Metaverse, and Meme-Stocks. While Tesla makes fine electric vehicles, the valuations given the company based on future robotaxis and full self driving defy common sense. All these improbable prices share the lie of immense riches for minimal effort and the unquestioning acceptance of their value narrative.

Many believe the most sustained pure speculative narrative-driven product is crypto-currency – and particularly Bitcoin. Bitcoin has proved irresistible to speculators with a whole series of sub-narratives supporting its’ axiom that Bitcoin is better money. Yet, strip away each narrative – or should we say not-truths? – such as the value of a halving, that this is libertarian money uncontrolled by govt, it’s digital gold, it’s ok to squander energy mining it, or Cathie Wood of ARK declaring its worth quintillions – essentially Bitcoin is a tulip that depends on the next greater fool being persuaded to buy it.

Such is the power of FOMO and Narrative even experienced financiers say they now buy into the Crypto story. Over the past 15 years the once clever and intellectually-curious financial markets have come to support a fairy-story that most closely resembles the Emperor’s new Clothes.

The lessons the market has taught since 2008 are critical. A whole generation of bankers, investors and city-workers have reached maturity working in markets where artificially low rates were the norm, where it was assumed central banks stand ready to step in to bail-out and rescue bad decisions and speculation is the norm. The lesson is clear. Markets are not clever. They are credulous. And low rates have deepened their ability to accept silly stories.

Flat Inflation and Rising Debt

As the QE era proceeded there was no sign of the inflation the doomster monetary economists had warned about. Inflation remained stubbornly flat across the Western economies – partly kept low because China was exporting deflation by remaining the cheapest to produce economy, but largely because very few corporates were actually raising money to invest in plant, productivity or people in the real economy. Had they done so, that would have triggered inflation in the goods and services required to build new infrastructure and factories.

Deflation was the main economic worry – even though inflation was hiding in plain sight in rallying financial asset markets as the money spawned by QE was invested back into stocks and bonds – barely touching the sides of the real economy.  They called it a rally – though some sceptics called it a bubble. Similarly, no one correlated rising home prices with asset price inflation… but proof buying a home was wise investment!

For corporates the decision on investments was not difficult – should they borrow money at the cheapest rate in history to invest in a relatively high-risk new factory producing new widgets to possibly achieve a target risk-based return, (at a substantial risk), or do they borrow money at the cheapest rate in history to fund a stock buyback, thus boosting the price of the company’s shares and their bonus options at almost zero risk?

This financialisation of markets has been progressing for decades – the pursuit of market value rather than real economic value – but it was massively accelerated by low interest rate distortions during the QE era.

Boeing provides a great example of how badly wrong financialisation could go. From its inception in 1916 right into the 1990s, “If it ain’t Boeing, I ain’t going” was the mantra of both pilots and passengers. Boeing succeeded because its’ tight team of engineers were able to deliver the finest, safest aircraft. In 1996 Boeing made a huge mistake – acquiring its’ ailing competitor, McDonnell Douglas – the intention being to make use of its product capacity for its growing backlog of orders for Jumbo Jets and the ubiquitous 737 Jet.

For many years the aviation industry joked at how McDonnell Douglas effectively acquired Boeing using Boeing’s money. McDD executives, cost accountants to a man, took over the firm, The HQ moved to Chicago away from the factory in Seattle. Cost control overtook engineering excellence as the firm’s mantra. The C-Suite might not have known Charlie Munger’s observation: “show me the incentive and I will show you the outcome”, but they realised their personal interests were best served by a higher stock price.

Boeing used the billions it made from sales of the successful B-747 Jumbo and B-737 airliners to make shareholders short-term happy through stock-buybacks. They could not resist the attractions of ultra-low QE interest rates, and borrowed even more from the market to keep funding buybacks – effectively taking on double leverage to retire equity with greater debt. The outcome was to make the board exceedingly rich from their options bonus reward programme. They used their oligopoly market power (and as the US’ largest exporter) to effect a capture of the US Federal Aviation Authority to ease regulatory approvals, believing they were immune.

And then reality caught up; the issues stemming from the financialisation of the company became apparent and their product reputation plummeted.

The new Boeing 737 Max – a Frankenstein plane cobbled together to put new engines on an old plane to avoid the high cost of developing a new model to replace the nearly 60 year old 737 – proved unstable, necessitating a fly-by-wire workaround Boeing didn’t properly explain to pilots until after 346 people died in crashes. The HR neglect of the engineers at the core of the business – who effectively became little better than minimum-wage operatives – has been illustrated by repeated incidents, including a door falling off in flight. During Covid Boeing sacked engineers and safety inspectors yet kept its accountants on full pay. Today Boeing lacks the capital to develop the new efficient aircraft airlines want to buy.

Boeing illustrates multiple behavioural issues than can be traced back to ultra-low interest rates; easy, plentiful, cheap money enabled Boeing’s C-Suite to award themselves larger and larger bonuses, secure in the knowledge their buy-backs would keep up the stock price, they enforced pay restraint and worse working conditions across the workforce.

The Boeing model: financialise the company to make the bosses rich, cut costs and de-power the work force, and regard customers as a necessary evil lies at the heart of the “Enshitification” of modern society, a most marvellous term coined by Cory Doctorow. It defines the process by which any service or product becomes increasingly more painful and difficult to use. A key example includes the no 1 corporate lie: “your call is important to us” in the queue for customer help – your call is not important, it’s just a distraction as far as the firm is concerned. Service is an unwelcome cost imposed on goods already sold!

The effect of enshitification is to cut costs, boost the bottom line, forget stakeholders and disregard the utility of the product. Pretty much describes vast swathes of the modern economy today where private equity (funded on the back of cheap QE money) is simply farming their companies for returns, largely unconcerned about their welfare.

Private Equity and Debt Bubble

Trillions of dollars of stock buybacks have now so reduced the number of shares free to trade that tiny free floats support higher multiples. Meanwhile the rise of the Private Equity (PE) sector, stepping in to buy public firms, or pre-IPO companies before they go public, has further fuelled the increased apparent valuation of public stocks by reducing their number.

The Private Equity sector has been enabled and thrived on the back of overly easy money – its dramatic growth from a mere $506 bln in 2007 to $8.2 trillion today has been fuelled by cheap, mispriced debt. A cynic might say the PE model is simple; a) acquire company, b) lever with debt, c) pay enormous dividends to the owner, d) sell the firm.

When interest rates are low the model works superbly well: when the street is awash with cash it’s not too much of a struggle to finance heavily indebted corporates. Only over-indebted corporates fail – the distinction is a subtle one. As interest rates normalise, watch the default rates rise.

PE firms are still finding plenty of money willing to invest in the perception of further equity upside, but obtaining the debt from the more cautious debt market is becoming more difficult, illustrating the truism that equity buyers are optimists, while bond traders are realists. In a higher rate environment more firms will struggle with leverage and debt – while the strongest will survive, all it takes is a few weaklings to fall and trigger a wave of market contagion – a falling tide that threatens to sink all ships.

Corporate failure is a critical element of capitalism. In a vibrant economy goods and services should be constantly improving while market niches should remain competitive – with new entrants bringing new and better products to market while incumbent companies that fail to evolve will fail and default to make way for them. In a low interest rate environment, the incumbents can remain inefficient and block innovation.

Let’s not waste time talking through the multiple failures of state infrastructure privatisation, and how populations are left with enshitified state utilities paying dividends to private equity owners.

Complexity and Returns

In the highly leveraged, debt dependent PE sector there are parallels to the GFC of 2008 emerging. Prior to the Fall of Lehman, increasingly complex and highly levered Collateralised Debt Obligation (CDO) structures emerged investing in other CDOs and CDOs of CDOs. Such Leverage on leverage is occurring across the PE sector where PE firms are funding their already levered portfolio companies from “Net Asset Financing” secured on the portfolio.

Among the surest signs of a coming crisis is increasing complexity in financial products, market leaders selling down, insider selling, and often grandiose new corporate headquarters for financial institutions. If Canary Wharf were not now so empty and cheap – we would be seeing a forest of new corporate palaces being built in London today.

Income Inequality and Populism

The reality of the QE era has been cheap money fuelling rising wealth among those fortunate to own financial assets. The rich, ranging across company bosses on stock-adjusted bonus packages, or those holding large financial asset portfolios have seen their wealth increase dramatically in line with the inflation in financial asset prices.

While it’s rare to see rampaging mobs of workers storming the legislative assemblies of the Western World these days – although we should acknowledge the Jan 6^th Capitol Hill insurgents – the workers of the world now largely have the vote to wield instead of pitchforks. The growing income inequality between rich and poor has spawned populism among voters. The success of Make America Great Again under Donald Trump plays right into the feeling of non-growth USA that for 20 years they’ve been left behind as the power elites of Silicon Valley and Washington have prospered.

In both Europe and the US, the growing resentment at the lack of opportunity and a rising sense of wrongness and injustice has been funnelled into racism – that it’s immigrants (rather than the financialisation choices made by management) that have cost jobs and prosperity.

The poor have seen their incomes flatline – barely matching even low inflation. Taxes have risen. Services have declined. Inflation – always a tax against the poor – energy costs and rising debt service costs have hit them hardest. It’s no wonder Americans paying 30% plus interest rates on credit card debt and more for second-hand autoloans see themselves as victims only MAGA can rescue.

The Virtuous Sovereign Trinity and Geopolitical Risks

Virtuous Sovereign Trinity (“VST”) theory is exceptionally simple: any nation that has a stable currency, a sustainable bond market and political competency will tend to do well. (Political competency is wide ranging – it should encompass the effectiveness of Central Banks, Regulators, and Bureaucracies. Lis Truss is the obvious example of failure, but so is the UK’s rotten planning system.)

When one of these VST legs fails, the economy will become unstable. At the moment the political competency of the West is being repeatedly tested – politics are polarised and the response of state agencies (Regulators and Central Banks) to crises are questioned. Its easy for outside players to exploit and confuse the narrative with counter-factual and fake-news, sowing division and weakness across Economies. It works because ultra-low interest rates have created a fertile have vs have-nots across Western Societies.

This puts nations on the defensive – most clearly illustrated in the recent agreements to fund Israel and Ukraine in the US Congress being achieved by uniting the divided house against China as the perceived common enemy. While China is clearly in competition with the US, is it really willing to risk its still volatile economy in conflict? That seems unlikely, yet political populism seems intent on driving us down that path.

Debt Burdens

A final issue to consider – perhaps the most important of all – is the sustainability of current debt burdens which dramatically rose for most nations through QE and Covid. As interest rates remain high, the cost of servicing the debt becomes and increasing burden. How can it be repaid?

Financially sovereign nations (which excludes EU members who surrendered their sovereignty to the ECB), can always repay debt by printing more money. That raises inflationary concerns, reflected in the currency and the price of selling further debt – but rising interest rates will tend to compensate. The other choice is to cut spending – austerity which is fine in theory, but raises impossible social costs. The reality for any nation is the cost of building and maintaining national infrastructure, welfare services (including health and education) and defence, are the classic “common goods”, for which funding is critical.

The next few years will require a complete rethink on debt burdens – and how nations can raise the necessary finance and sustain it. That might require a little lateral thinking – so let me finish with Zonk Theory.

At present the Bank of England holds about 30% of the UK’s outstanding Gilt Market which it is trying to sell (QT). That debt is an asset of the Bank, but a liability of the UK Treasury. They are matching items on the national balance sheet. The money created by the issue of the gilts has long since flowed into the economy (or financial assets). What if the UK treasury were to give the Bank a “Zonk”, a single coin denominated at the same value as its Gilts portfolio. It could then rest for eternity in the Bank’s rather fine museum. It would mean the UK’s debt to GDP ratio would fall to 70% – giving the headroom necessary for infrastructure, defence, and health refits.

If nothing else, Zonk theory gives hope there may be other ways to solve the current economic headroom issues, and partially overcome the hangover from the QE era.

Bill Blain, April 2024

 

Bill Blain is a 38 year Capital Markets Veteran, and principal of Wind Shift Capital, a dedicated firm advising in Alternative Capital Markets. He publishes the daily Blain’s Morning Porridge – an irreverent market commentary.

Much to everyone’s surprise in 2023 Heriot-Watt University’s Edinburgh Business School appointed him honorary professor of Social Sciences, lecturing post grad Investment Management students. Bill graduated MA Economics from Heriot Watt in 1985.