«Switzerland is famously neutral in geopolitics, but it is proven that it cannot be neutral in the geopolitics of money.»
Central banks have pushed the alleged zero lower bound of interest rates to the sub-zero zone, and they have reached heady heights with their towering balance sheets. Monetary policy is exhausted. Or is it? James Grant predicts that central banks will remain creative and monetary policy will be astounding. One of the biggest issues is the absence of price signals in bond markets, says Grant, who is editor of the renowned investment newsletter «Grant’s Interest Rate Observer» in New York. He gave a keynote speech at the Fund Experts Forum 2019 of «Finanz und Wirtschaft» in Rüschlikon, Switzerland.
Mister Grant, the Fed and the ECB have suspended the normalisation of monetary policy. What’s next?
The tendency is that policy becomes ever more innovative, to use a gentle word, more improvisational. And so one concludes that radical policy begets more radical policy.
Do the measures of the central banks wear off?
Exactly. It takes an ever greater infusion of stimulus to obtain the same stimulating result. It must be a little bit like medication: The dosage that did the job for you last week is not the same dose you need next week.
What does the Fed do when the economy falls into recession?
To borrow from ECB’s Mario Draghi, the Fed will do whatever it takes. I think they would resume quantitative easing QE. There are no protocols in place that would tie their hands. There is no such thing as classical central banking whose rules they must adhere to. They are free to, as you put it, fish around in the toolkit for new wrenches and hammers and chainsaws.
Will the Fed consider negative interest rates?
Yes, they talk about these things quite openly. The San Francisco Fed is out with a piece of how negative interest rates might be necessary. I think they are open to all radical methods.
The ECB has negative rates already and hardly any ammunition, when the next recession arrives.
They’ll think of something. Why wouldn’t they use even more radical measures? Monetary policy will be more extreme, more astounding.
As with the forerunner, the Bank of Japan?
I guess it is not a very encouraging example. The Bank of Japan has destroyed the bond market. Mario Draghi has also destroyed the bond market.
How is the destruction of the European Bond market visible?
A little more than a year ago, Telecom Italia (TIT 0.56 -1.01%) had a short-dated speculative grade note outstanding. It was priced to yield zero point something, that is 0,8%. A junk bond with a yield that begins with the integer nought. I think it’s partly my frame of reference, but the idea of a junk bond beginning with the integer nought to me is mind-blowing.
Low interest rates support companies.
The bond market is supposed to give you an accurate reading on the credit worthiness of the companies that are borrowing. The function of the market is to appraise the value of the securities on offer, to say it’s good, it’s bad, it’s speculative, it’s investment grade.
This differentiation is not prevented by the central banks.
If the central bank is buying everything, there is no short selling in the market. Everyone has to own, everyone is indexed. The very function of a market is destroyed. Prices become not indices of value, but rather indices of central bank action. Is that wholesome, is that good? Interest rates are the most critical prices in a market economy. Prices should be discovered, not administered.
Will all this continue permanently?
Central banks will take the path of least resistance. What they want is to break no teacups, so to speak. They don’t want the stock market to go down. They don’t want the business expansion to end. And to that end, with those goals in mind, they will continue to be accommodative, and they will err on the side of lower rates rather than higher ones.
Where is the danger of such policy?
Very low interest rates incite speculation, misdirect investment, stimulate credit formation and thereby store up trouble. This was observed by Walter Bagehot in the 19th century, he was chief editor of the «Economist» and noted: «John Bull can stand anything, but he can’t stand 2%.» The bull market could not handle such low interest rates.
Nowadays, markets fear rising rates.
Uncle Sam can stand anything, but he can’t stand 3%. Maybe we can’t stand a rate as high as 3%, this could be a tipping point, because of the structure of our finance, because of the leverage in place. I’m not sure it is so. But if it were true it would be a very strong indictment of central bank policies. It would say that something very undesirable has happened under the stewardship of the central banks.
Apart from leverage, are there further undesirable side effects?
Very low interest rates tend to sap economic dynamism. There is an OECD working paper about that. Thus, labour productivity is stifled because of the prevalence of zombie firms, which have persistent problems meeting their interest payments. Zombie firms constrain the growth of more productive firms, they congest markets and tie up resources. Furthermore, low interest rates encourage market concentration and advantage the rich over the poor.
What is the effect of all this on financial markets?
Central Banks have been attempting to create prosperity by boosting the prices of stocks, bonds and real estate. This creates bubbles and therefore new booms and busts. The Fed’s official dual mandate is to foster stable prices and full employment. Its de facto dual function has become that of arsonist and fireman.
Where are these problems most evident?
In America, some of the most grotesque distortions are the valuations of our so-called unicorns. The unicorn is a loss making start-up company, typically in technology. They don’t make money but lose a lot, and they have been enabled to do this through very low interest rates and very accessible capital markets. However, one of the biggest problems we face in America is the student debt, which amounts to well in excess of a trillion dollars.
What happens to the student loans?
I’m surprised that so far no enterprising unscrupulous politician has said: Let’s write it off. I could give the speech myself: «Let’s forgive it. We’ll all be happier. And we’re rich enough to bear this. It’s a matter of intergenerational equity and of justice to our young striving people. Let us save them from the coils of this lifelong burden. They have had enough to bear.»
Who would pay for this debt?
The Fed will pay for it – I’m just trying to imagine what’s next. I can see the sketches, I can see the Fed paying for debt. In Europe, among the worst of stories are sovereign yields. Pick out the weakest government in Europe. You’ll find that it borrows for less than 1%.
The low interest rates in the Eurozone are a problem for the Swiss National Bank.
I am very glad I’m not running the Swiss National Bank, and I’m not sure what I would do in their place. Switzerland is famously neutral in geopolitics, but it is proven that it cannot be neutral in the geopolitics of money. The policy goal of maintaining a Swiss Franc exchange rate that does not bankrupt every single exporting company in Switzerland is defensible. But the SNB (SNBN 5'320.00 -0.37%) has undertaken to buy all the Euros it can or it must, and invest some of those proceeds in dollars, and with those dollars to buy stocks and to thereby accumulate a fund that’s bigger than many American mutual funds. It’s grotesque.
What do you think about the future of the Euro, which is so important for the SNB?
The euro is a piece of paper that seemingly is destined to be of very little value. And to keep up that debasement, the Swiss National Bank is doing what it has done. This is not my idea of what Switzerland stands for in monetary affairs. But it is evidently what Switzerland regards as necessitous and expedient. So as an American, I will not judge but observe.
Where is all this leading to?
Under the gold standard, there were rules in place. If gold left the country, the central bank raised interest rates to lure it back again. A central bank did not monetize government debt. There are no such rules today.
The gold standard with its rules failed.
It was the least bad system. Certainly no system is perfect or fool proof. The weakness of every monetary system is not necessarily the nature of money or the rules of the central bank. It’s the institutions of credit, of borrowing and lending, which get monetary systems into trouble. The ever-present issue is: How do you restrain the seemingly inherent tendency of people to overdo it, to lend and borrow too much? And the second ever-present issue: How do you deal with failure?
How then should we deal with crises?
In the present day system, everything is in place to postpone the recognition of error and failure. And under the gold standard you had to confront it, and the bankruptcies were more violent but the recoveries were faster.
Crises should be allowed rather than being contained?
What systems are desirable, what to people want? Should it be a system in which we bear some short-term pain in the interest of greater dynamism and faster recovery. Or should it be something in which no one is really hurt, and where we stumble along with more and more zombies and with less and less dynamism. Those are the choices.