global financial systems chapter 5 the central bank. part b · global financial systems © 2019 jon...

Global Financial Systems © 2019 Jon Danielsson, page 1 of 55

Post 2008 Bailing Growth Markets Inequality Normalization

Global Financial Systems

Chapter 5

The Central Bank. Part b

Jon Danielsson London School of Economics© 2019

To accompanyGlobal Financial Systems: Stability and Risk

http://www.globalfinancialsystems.org/

Published by Pearson 2013

Version 6.0, August 2019



Book and slides

• The tables and graphs arethe same as in the book

• See the book forreferences to original datasources

• Updated versions of theslides can be downloadedfrom the book web pagewww.globalfinancialsystems.org



Post 2008



Post 2008

• The immediate reaction to the crisis in 2008 was• sharp reduction of central bank interest rates to almost 0• massive QE• direct liquidity assistance (discussed in a later chapter)

• Since then, interest rates have remained very low

• Some countries, especially EU, continue to do QE

• Is this a permanent structural break?

• What are the dangers?



Long–term inflation

• Post crisis liquidity creation programs would have beenhighly inflationary if implemented before 2007

• But the recent low inflation environment shows there arestill strong deflationary forces

• Empirical research on interest rates suggests they aremean reverting

• Consider the example of the BoE, with an historicalaverage of 5.25%

• The current near zero intrest rate is quite anomalous



Bank of England rates

1700 1750 1800 1850 1900 1950 2000

0%

5%

10%

15%



Where has inflation gone?

• Various QE programs have not lead to an increase ininflation as they would have done before 2007

• One reason is that banks have not been lending thefreshly created money

• While poor labor market conditions have prevented salarygrowth

• But unemployment is almost record low in many countries

• We do not understand why inflation has not gone up



2016long run return is annual total stock market return 1899-2015

Germany Japan UK USA

0%0%

5%

10%

15% Growth

Inflation

Stock market

Unemployment

inflation

target

long run

total return



US

• Economic growth is picking up

• Labor market is tight, salaries are increasing

• Asset prices are increasing

• Inflation is increasing

• Rates are in the slow process of normalizing



EU

• Some countries are like the US, which would call fornormalization

• But others are suffering, calling for continuing status quo

• If more European economies start picking up growth,employment and inflation is sure to follow

• The two track Europe (discussed later) makes it difficultfor the ECB to stop QE or increase interest rates



Can low interest rates last?

• A common view maintains that things are different

• Interest rates can be permanently lower without inflation

• This is wrong

• Inflation remains low because economic activity is low,and economic agents expect low inflation

• But expectations can shift rapidly

• If economic growth increases, putting pressure on thelabor market

• And/or if agents expect higher inflation

• Funding costs, investment, prices and wages will all beaffected



From self-reinforcing low interest rate

environment to high inflation environment

Expecting low inflation

Prices and wages don’t move

Funding costs low

Expect inflation

Funding costs rise

Prices and wages increase



Fragilities

• Recent monetary policies have made the private andpublic sectors dependent on low interest rates

• Zombie firms that only survive because of cheap credit• Zombie companies walk among us

• So it is harder to increase rates if and when inflationincreases

• Example of the FED dilemma now

• Market participants’ expectations might shift rapidly,shifting to a high inflation environment (see next slide)

https://www.ft.com/content/40c44992-17c3-11e8-9376-4a6390addb44



Debate about QE and low interest rates

since 2008have to, else depression depression when it ends

save the banking systemfrom collapse

encourages reckless behaviormoral hazard

without it economic activitywould collapse

excessive debt was the causeof the crisis

creates jobs for the poor benefits the super wealthy

there is deflation inflation will happen

structural reforms too hard prevents structural reforms

bad for savers lifeline for borrowers



Bailing Out Governments



Bailing out governments

• It’s not one of the four core functions listed above

• But always has been a core function

• Even a founding function• BoE founded to help with war funding

• Usually viewed as dirty or unseemly

• However, under the right conditions it is appropriate

• We see the danger a few slides down



Mechanisms

• Print money and buy government bonds

• Unexpected inflation• Why can’t it be expected?• Cagan double exponential model below

• Seigniorage



Central bank holdings of government bonds

relative to GDP, end of year

0%

4%

8%

12%

16%

2005 2006 2007 2008 2009 2010 2011

UK

USA



Pros and cons

• Only recommended in exceptional circumstances

• When done routinely it locks in inflationary expectations— very costly to eventually fight

• If the economy is in deep recession (way below outputpotential)

• And inflation negligible

• Justified for two reasons

1. relieves pressure on government2. reverses contracting money supply



Growth



How to get growth?

• Some commentators argue that we are now in “secularstagnation”

• Or, we are not just able to implement the right structuralreforms

• Perhaps, as some (e.g. ECB) maintain that liquiditycreation is essential for growth

• That argument is outlined on the next slide



Central bank liquidity can be essential for

growth

• The main driver of economic activity and jobs is SMEs

• They need to get credit

• They are not getting enough from traditional sources• usually banks, except the US• every country in the world except the US is bank

dominated• one alternative is the Capital Markets Union in Europe• and even Fintech

• So it is necessary to create new money

• That will be lent to SMEs

• Creating jobs and growth



Is that correct? It depends

• In the US, at full employment and with diversified marketfor SME credit, probably not

• In depressed European states, qualified yes, the ECB maybe the only source of credit to SMEs (but see next slide)

• In well performing European states, probably nots

• In Japan, 50/50

• In the UK, probably not

• In China, probably not

• Why? next slide



Why “probably not”

• Liquidity can at best only help growth in the short run

• Liquidity provision undermines the support for necessaryreforms

• Short–term benefits prevent long–term support forreforms

• Liquidity programs just “kick the can down the road”

• “Plaster/bandaid on cancer”

• And build up problems for the future



Financial Markets



Impact on financial markets

• Liquidity injections would have prevented bank failures inthe US after the Great Depression

• And did so in 2008

• Liquidity injection aimed at banks is controversial

• Discussion on bailouts in Chapter 14



Market distortions and bubbles

• Liquidity creation distorts markets

• By encouraging risk–taking that private entities otherwisewould not take

• Financial markets have become less likely to appropriatelyreact to good or bad economic news affecting the valueof an asset

• Negative macro–economic news in Europe in 2014 led toa market rally rather than a drop

• Deteriorating economic conditions increased thelikelihood of the ECB adopting QE



Global GDP and market capitalizationtrillions. Bloomberg WCAUWRLD index

2005 2010 2015

0

20

40

60

80 World GDP

World market cap



Unexpected/undesirable consequences

• Low interest rates should increase borrowing by providingcheap money

• Instead of investment, people start saving more (seeearlier discussion)

• And asset markets are affected (see next slide)



Where does the money flow to?

• Most asset classes (fixed income, equities, real estate)have performed well since the crisis

• When able to borrow at very low rates to buy wellperforming risky assets, it attracts funds

• Especially since many traditional investments (bankaccounts, short-term government bonds) yield next tonothing

• So money flows into the asset markets

• And when central banks do QE they buy bonds, furtherincreasing performance

• And some central banks buy equities

• A positive feedback process



Market distortions and bubbles

• Liquidity creation distorts markets

• By encouraging risk–taking that private entities do notwish to take

• Over time, divergence between Wall Street and MainStreet became bigger and bigger

• Financial markets have become less likely to appropriatelyreact to good or bad economic news affecting the valueof an asset

• Negative macro–economic news in Europe in 2014 led toa market rally rather than a drop

• Deteriorating economic conditions increased the likelihoodof the ECB adopting QE



Consequences

• Bubbles burst

• Inequality (next section)

• Normalization (section after next)



Inequality implications ofliquidity programs



Background

• The motivation for low rates and QE is to help SMEs andhence workers — especially low income and wealth

• However, the impact on asset prices has been strong

• And salaries have been stagnant or fallen in real terms• But can be hard to disentangle from globalization and

technology affects• We don’t know the counterfactual, what would have

happened to wages in the absence of the program

• Interest rates are often real negative

• So those on fixed income have seen their real income drop



UK 2012Household wealth by decile in £1,000s

1th 2th 3th 4th 5th 6th 7th 8th 9th 10th

£0

£200

£400

£600

£800

£1000

£1200

Property Financial

1th 2th 3th

£−10£−5

£0£5

£10£15£20



Income and wealth distribution

• The liquidity policies post–crisis have changed thecomposition of winners and losers

• Even if low income people earn x% more, if the wealthyearn y% > x% more, inequality increases

• Biggest losers are poorer savers, retirees and pensionfunds

• Liquidity creation is likely to affect income distributionthrough three main channels

• Next slides...



1. Income composition channel

• Households receive income from their work andinvestments

• Accommodative monetary policy helps companies’ profitsdirectly, and increases asset prices, but has a lower andonly indirect effect on wages

• People who own financial assets and companies aretypically wealthier than the average

• So income benefits flow primarily to those with incomeother than work



2. Financial segmentation channel

• The financial sector is a direct beneficiary from thesupport given to the financial markets

• People employed in the financial sector already receivehigher incomes and are wealthier

• So accommodative monetary policy benefits the highestearners

• Widening the income distribution gap



3. Portfolio channel

• Wealthier households are those that own assets• companies• equities• real estate

• While poorer households own less, or are net debtors

• Any policy that supports asset prices will increase thewealth gap



Average relative equality implications

winnersloosers

Poorer/unsophisticatedsavers

Pension funds

Retirees

Low earning/wealthhouseholds

Wealthy/sophisticatedsavers

Company owners

Financial sectorworkers



Equality implication flows

Low ratesand QEWage earners

Fixed income

Company owners

Financial asset

owners

Financial sector

workers



So

• Equality is not a CB mandate

• FED and BoE justified their QE program by a trickle

down argument: eventually, everybody should benefitfrom liquidity creation

• ECB argues that it benefits SMEs and those who work forthem

• The BOE found that, in the UK, the benefits of QE wereheavily skewed towards the top 5% of households, whoown 40% of assets



Normalization of interest rates



Normalization

• Inflation should hit its target

• And interest rates get close to typical rates

• There are many challenges



Borrowers and banks

• Unprofitable borrowers may get into serious difficultieswhen interest rates rise

• Today, banks are able to “extend and pretend” or“evergreen”

• When rates increase banks can no longer do so as easily



Sovereign borrowers

• Most sovereigns are highly indebted

• But most borrow in their own currency

• And have long maturities (often close to 10 years)

• So they only have to roll over a relatively small portion ofdebt



Impact on savers

• Most buyers of long bonds have no choice• reserves, social security funds, pension funds, insurance

companies

• When rates go up their demand will change in predictableways

• When other bond investors start seeing losses will theyrun for the exits?

• Will we see a bond crash?



Bond returns under various scenariosVoxEU.org (2016) Balazs Csullag, Jon Danielsson and Robert Macrae

inflation

real re

turn

−100%

−50%

0%

50%

100%

150%

200%

250%

300%

−2% 0% 2% 4% 6% 8%

United States

United Kindom

Germany

Infla

tion

targ

et

1860s1870s

1880s1890s

1900s

1910s1920s1930s1940s

1950s

1960s

1970s1980s1990s

2000s2010s

http://voxeu.org/article/why-it-doesnt-make-sense-hold-bonds



The role of the US in global liquidity

expansion

• The US dollar is the reserve currency

• Learning from history: the FED injected liquidity to avoidthe recession experienced during the Great Depression

• Other countries had little choice but to follow the USmonetary policy

• So the liquidity creation program was exported



The end of accommodative monetary policy

• QE program was stopped in October 2014

• US employment, inflation and growth have risen

• Fed increased policy rates in December 2015 by 0.25%,and twice this year

• EMEs and investors prepared and already priced indecision

• Different than Taper Tantrum (2013, next slide)

• But debates remain:• Has the US economy recovered enough?• What will be the impact on international markets

(particularly EMEs) in case of further increase?



Taper Tantrum - 2013

• Bernanke announced the progressive interruption of theQE program in May 2013 and a potential hike in policyrates further ahead

• Severe impacts on EMEs:• Capital outflows from bond markets• Increase in bond yield spreads

• So rising rates could have severe impacts (short- andlong-term) on markets

• But the US law only considers effects on the US, notother countries



Three major concerns

1. Offshore and foreign currency-denominated securitiescarry with them high currency risks; Investors are notconvinced about the strength of EMEs economicfundamentals

2. FED rates hike may trigger a repatriation on US dollarassets and bring EME currencies downwards; EME will bepushed to raise rates too, increasing EME corporates’debt burden

3. Maturity of EMEs’ overseas debt has increased, whichenhances duration and volatility risk for investors



Feedback

Tapering

yieldcurvesshift up

FX ↓

corporatedistressGrowth

↓

assetman-agersrun



ECB

• The ECB faces on average weaker economy than the US

• Buys e60 billion a month

• ECB can only by a 1/3 of a countries’ bonds, and thisabout to hit that with Germany

• And generally it is buying shorter and shorter bonds

• It is signaling slowing down QE

• But not yet increasing interest rates



So

• The continuing low interest rates and QE programs havebecome an essential part of growth

• But do they create problems for the future

• The longer the CBs delay normalizing, the harder it will be

• Strong impacts on both savers and borrowers

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