(Free) Radical policies

The first trading month of the New Year is over. Month-end window dressing on Friday saw stocks around the world rally hard. Otherwise, the month was a dreadful one for stock markets. Arguably, the Bank of Japan decision to push interest rates into negative territory (lenders pay!) had something to do with it. Many have blamed the US Federal Reserve for the turbulence and losses in stock indices. Instead, they should have sent a note of thanks to the Federal Reserve for blowing a bubble in the first place.

For example, one tweeted that, thanks to the Federal Reserve rate hike in December, financial conditions have tightened materially—the economic equivalent of four rate hikes. The same person tweeted later that cracks had emerged over the past six months in leveraged credit similar to late 2007 in the mortgage market.

Readers should be able to notice the contradiction between the two tweets. Cracks had emerged over the past six months and the Fed tightening happened a month ago. Spreads on high-yield bonds began to widen from 2014. Indeed, Jeremy Stein who left as the Federal Reserve governor in 2013 had already warned of risks in the corporate bond market. Neither of these was caused by the Federal Reserve raising interest rates.

On the contrary, they were caused by the Fed holding policy too easy for too long. What the Federal Reserve did in 2008-09 was fine. It had to take urgent fire-fighting measures without much time for reflection on their costs. However, the expansion of its quantitative easing programmes in 2010 and 2012 is an important source of all the troubles that the world is facing now.

Bloomberg reports that the debt-equity ratio in global corporations rated by Standard & Poor’s is at a 12-year high. The Bank for International Settlements has noted that public and private sector debt have gone up in all countries around the world since 2007. If too much debt-induced asset bubbles caused the crisis of 2008, our policymakers had decided that asset bubbles created by further debt accumulation was the answer to it.

S&P 500 has a median price/sales ratio that is higher than the one that prevailed in 2000. The current four-quarter trailing price-to-earnings (PE) ratio is not cheap either at 21. S&P 500 profits have contracted in two consecutive quarters. The Russell 2000 stock index has a PE ratio of over 108. Borrowing money to buy stocks back has supported stock prices. Corporate executives have engaged in financial engineering to boost stock prices so that their compensation rises. Stock prices have become untethered from fundamentals. Bubbles have to burst and they do so of their own accord. No specific causal factor is necessary. If it were not the Fed, it would have been China. We should be questioning the emergence of another bubble, partly contributed by policy and partly contributed by corporate greed and yet, the blame is on a 0.25% rate hike.

Again, unmindful of history and, more specifically, recent history, commentators have focused on low headline inflation in the US when one of the purported lessons of the 2007-08 crisis was that the single-minded focus on consumer price inflation was the cause of the neglect of financial stability considerations. The Fed repeated its mistake between 2009 and 2014. Very few criticized it but now, they are berating it for its belated move away from insanity.

Somewhat unsurprisingly, Martin Sandbu (‘Free Lunch’ in Financial Times) had cheered the move towards negative interest rates in Japan. For good measure, he concluded with exasperation that it took them too long to get there. Well, some of us are exasperated with commentary such as the above. When the consequences are factored in, we will be wondering why they abandoned their last vestige of discretion, prudence and common sense rather than asking the question of why it took them so long.

Negative or 0% interest rates might work if ‘other things are equal’. In reality, other things do not remain constant. They keep evolving. In theory, interest rates = compensation for postponing consumption + inflation premium (for relative scarcity of goods over money, over time).

The first component is mostly a constant through time. Hence, if interest rates go negative, what is happening is that the inflation premium goes deeply into negative. In other words, the message goes out that there is no need for inflation premium and that there won’t be a relative scarcity of goods over money. In other words, it is a signal that there is no reason or incentive to invest in physical or real assets—the opposite of what central banks say they are trying to achieve through unconventional policies.

Most commentators have not learnt the golden rule that economic theories are only approximations and are hence points of departure. In their ignorance, they have made false heroes out of central bankers and have heralded false economic dawns. In medical parlance, they are the ‘free radicals’ that emaciate systemic immunity, making future economic illnesses a regular affair. Well, the ‘good’ news is that we won’t have to wait too long.

V. Anantha Nageswaran is an independent financial markets consultant based in Singapore.

Comments are welcome at baretalk@livemint.com. To read V. Anantha Nageswaran’s previous columns, go to www.livemint.com/baretalk