Focus on real economy, not QE

Think Asian

ON Sept 15, it will be six years after the collapse of Lehman Brothers. With the US economy still operating below par and Europe struggling to stay above water, the question is whether the medicine applied after 2008 was right?

The mainstream diagnosis was that the problem lay in excess credit and the need to control banks and shadow banks through more regulation and capital, bail-ins and a cap on overall leverage ratio. Since the politicians were not willing to push fiscal policies to the limit, the central bankers opted for massive quantitative easing or QE to stimulate the economy and simultaneously tighten regulation to restrain the naughty bankers.

But who allowed the excess credit in the first place to create asset bubbles at excessively low interest rates before 2007?

One can fully understand that under crisis conditions, you need to stimulate the economy and control the bankers. But in controlling the bankers, why have they been fined US$100bil plus so far, with a further US$150bil to go (according to FT estimates), after QE subsidised them US$300bil, according to IMF estimates?

Furthermore, why are half the fines for breaking sanctions and not for making banks fail in the first place?

These lofty central bankers and regulators have forgotten that finance is a derivative of the real sector. If the underlying asset (the real economy) is sick, fixing the derivative (finance) won’t solve the problem.

Fixing finance is like strengthening the cart but ignoring the horse. If the horse is overleveraged, giving it more debt won’t make it run faster. Thus, it makes more sense to inject more capital to the real economy (the engine of growth), rather than the banking system.

Indeed, asking bankers to top up capital, particularly from overleveraged governments to borrow more to invest in banks facing lower returns from higher regulatory costs and lending constraints does not make any sense. If the government has to increase debt, let it inject capital into the SMEs and infrastructure to push for real growth.

In other words, the world is short of equity, not more debt.

There are several culprits for debt before equity. The first is ideology. One of the foundations of modern finance theory, the Modiglianni-Miller theorem suggests that the value of a firm is indifferent as to its capital structure being debt or equity. This assumes no bankruptcy, perfect information and no tax differences. Theoretically, this is brilliant, but practically, it says that the market should be indifferent whether a legal person lives as a drug addict or a pastor, as long as that you assume that there is no death.

The second is tax biases against equity. Both interest on debt and provisions against non-performing debt are tax deductible, whereas dividends are taxable and capital losses are non-deductible. Indeed, US cash-rich companies prefer to keep their billions in cash abroad and borrow to pay dividends for purely tax reasons.

The third is the inherent hierarchy of finance. Monetary policy is exercised through central banks at the apex providing liquidity (debt) when needed to a select core of too-big-to-fail banks, which will lend to the masses at the bottom depending on the right incentives. If central banks lend to banks at near zero interest rates and banks can buy risk-free government securities which rise in price when they buy, are you surprised that they are not lending to the real sector?

Furthermore, if bankers take risks and lend to those at the bottom of the pyramid with higher credit risks, they are likely to be admonished by their regulators for allowing non-performing loans to rise and therefore should provide more regulatory capital.

It is not surprising that credit to real businesses is still stagnant six years after the crisis.

The hierarchy of finance fundamentally means that helicopter money from central banks inherently exacerbate social inequality. Central bank provision of low interest rate funds to a small circle of banks and fund managers who buy government securities from the central banks is de facto 1% subsidising the 1%, not the 99%.

Notice that instead of buying government securities, the People’s Bank of China recently injected liquidity back to the real economy through lending 1 trillion yuan to the China Development Bank to help finance shanty town reconstruction. This is exactly what the central banks in Europe should be doing to get growth back into the system – get money or housing into the people who need funds.

It is amazing that after six years of painful stagnation, Europe is still debating on the need for more austerity. The gold standard was abandoned in the 1930s, because it exacerbated deflation. During the early stages of the Asian crisis in 1997, this was tried in the crisis economies with disastrous results. The only way that Greece and other crisis economies can get out of recession is to revive growth.

What worries me is that the cut in interest rates by the European Central Bank plus more QE becomes another way of getting depreciation of the euro relative to the dollar. Since Aug 1, the euro has depreciated from 1.34 to 1.29 to the US dollar. Similarly, the yen has moved to a six-year low of 106 to the dollar.

The central bankers are still pushing QE and lower interest rates because the politicians won’t act faster on structural reforms. With geo-political tensions rising in Ukraine and the Middle East, it is amazing that market volatilities in equity and bond markets have become as low as the level just before Lehmans in 2007.

Since we have not recovered to growth levels in advanced markets and emerging markets to pre-2007 levels, the only thing that seems to be supporting the buoyant financial markets is loose monetary policy.

What is clear is that when the Fed starts calling for an end to QE and US interest rates rise, the markets are already preparing for some rather rude shocks. Watch for the smart money being taken off the table through the tech bubble.

Tan Sri Andrew Sheng is former president of the Fung Global Institute.