The Slippery Market Slope Steepens

Real Clear Markets

Jeffrey Snider is President and Chief Investment Officer of Atlantic Capital Management, a registered investment advisor.

It has been an interesting week in the markets. There are several developments that compete for rightful and careful consideration. The Swiss franc is perilously close to its 1.20 peg to the euro, perhaps inviting more currency intervention (the last time the franc strengthened as much was late July/early August – a time of great turmoil). In addition to money seemingly moving toward the relative safety of the franc, the ECB announced that dollar swap usage with the Federal Reserve Bank of New York (FRBNY) rose to a level not seen since 2009 (higher than even those desperate summer days of 2011). But perhaps the biggest news was an announcement by the U.S. Treasury that it planned to study allowing negative nominal interest rates on t-bills, while at the same time issuing floating rate notes on longer-dated issues.

The potential for negative nominal interest rates, in my opinion, takes the prize for most significant of all the news. The other events highlighted above are really just continuations of the ebb and flow of the banking crisis as it has persisted for nearly five years now. But any move toward negative nominal rates is potentially a sea change in thinking and policy.

Of all the many competing strategies that vie for supremacy in policy action, there is a desperate impulse to get money moving in the real economy. In mainstream economics this is known through the simplistic, mathematical equation of exchange. Monetary policy works on one side of that equation as either the quantity of money or velocity (in an oversimplified form). The quantity of money has been the consistent explicit focus of monetary policy to date. By increasing the supply of money, policymakers hope to see a rise on the other side of that equation, as either rising prices or increased output (or, in a perfect academic world, both).

Quantitative easing, as the name implies, increased the supply of money to banks through open market operations carried out by the New York Fed. These consisted of swapping newly created « cash », a balance sheet entry on the Federal Reserve System’s collective statement, for mortgage bonds and government bonds on the books of primary dealers. These twenty or so banks were then supposed to use those excess « reserves » in the interbank wholesale markets, with these new dollars making their way into Fed funds or eurodollars, funding the dollar-denominated lending activities of banks all over the globe. Right away banks resisted new lending, however, primarily due to equity impairments leftover from the real estate bubble’s collapse (both marked and un-marked). There was simply no spare balance sheet capacity to advance new credit (showing up as much tighter lending standards).

Without excess equity capital, banks, with all this new near-zero interest cash, had to put those reserves to work somewhere to generate some kind of return to begin to repair their collective equity. So the global system switched to sovereign debt, with its bureaucratic definition of safety expressed by a zero-risk weighting. The Fed’s experiment with increasing the money supply had no impact on the real economy (outside of commodity prices reacting to intentional inflationary expectations through dollar devaluation, an implicit attempt to influence velocity), but it served as a channel to fund the disastrous transition from mortgage bonds into government debt, especially higher yielding PIIGS.

Beginning in late 2010, but especially in March and April 2011, it became clear that the unserious efforts of European authorities to calm markets were grossly inadequate, and further that the situations in each of the PIIGS were both very susceptible to contagion and far more dire than previously stated. That started a sustained shift out of PIIGS and into other « safe » sovereigns, especially German bunds and U.S. treasuries. However, since a lot of these PIIGS bonds were pledged as collateral in funding arrangements (repos), just as the mortgage bonds were before the 2007/08 crisis, the element of liquidity crisis returned with a vengeance.

Once again wholesale funding markets froze, meaning all those trillions in newly created dollars were essentially stuck no further from the Fed than its inner-ring primary dealers. For all its trouble (and ours), increasing the supply of money has not only failed, it has directly led to economic retrenchment through commodity prices (weak consumer spending and now falling corporate profit margins) while solving nothing in the realm of global banking.

These were the exact considerations that put the Fed on hold last fall when all of the western world was sure QE 3.0 was coming. Rather than a large expansion of its balance sheet (another attempt at increasing the quantity of money), the Fed opted for Operation Twist (where its balance sheet size would be held steady). Instead of QE 3.0 in January 2012, as many were expecting, the Fed simply extended the time horizon for ZIRP (zero interest rate policy).

There were and are operational considerations regarding any new QE that has kept the Fed away from quantity policies. Despite it being counterintuitive given the $15+ trillion in outstanding U.S. treasuries, 2011 saw a desperate shortage of U.S. t-bills for repo collateral. It was one of the prime features of last year’s liquidity crisis – a tremendously shrinking pool of low-haircut, liquid collateral for funding arrangements (reversing the trend of rehypothecation has also played a role here). Since the Fed’s QE programs took up so much of the available supply of « on-the-run » t-bills (these are the most liquid treasury securities that make up repo arrangements), the banking system was in danger of having too little low-haircut collateral. So another round of QE would have actually made the liquidity crisis of the summer even more intense, and the Fed knew this (conducting reverse repos over the summer in advance of an Operation Twist that sold t-bills back into the collateral market).

This shortage of collateral was expressed as negative t-bill yields. Banks were so desperate to avoid haircut expansions from the junk on their books, they were willing to buy U.S. t-bills and accept the small loss on principal that the negative yields implied just to gain access to repo funding at those low haircuts.

Narrowing the list of low-haircut collateral has completely thwarted the quantity of money solutions (as well as the lack of sufficient systemic bank equity). Without the ability to get new money flowing into bank credit production, especially with the Fed belatedly aware of these operational constraints and realities, it is increasingly likely that we will see more determined efforts to interfere in velocity. After all, with that simple equation of exchange, if one variable fails to generate results, there is another to control.

In the days of the Great Depression, this kind of behavior by individuals would have been damned and condemned as « hoarding » money. In fact, the great collapse in money stock of that period was entirely due to the almost infinite demand by the public to hold physical currency instead of bank deposit money. In the fractional money system, such hoarding inverted the credit pyramid, collapsing the wider money stock, simultaneous to the drop in spending velocity, creating the dreaded currency disease of deflation.

We have a similar pattern going on here, but entirely within the banking system itself. Banks are hoarding quality collateral, blunting any quantity of money attempts by the Federal Reserve to push lending into « riskier » sectors, or to increase the quantity of credit advanced. The typical academic response to this kind of activity is to penalize it (economics has a pre-occupation with incentives, especially negative incentives). If banks, so this line of thinking goes, refuse to invest in anything other than « safe », collateral shrinkage or not, then they will have to pay for it.

I should note here that there is a tremendous difference between the negative yields on t-bills that occur now during periods of hoarding and negative nominal interest rates. Negative yields are happenstance occurrences of free trading. Negative nominal rates are explicit attempts to control the appetites and desires of financial participants. Economists have fantasized about negative nominal rates for years as a way to go beyond the dreaded zero bound. In fact the whole idea of generating inflation expectations (the velocity element of quantitative easing) was to create negative real interest rates to penalize holders of money balances, making saving expensive and spending more appealing (in theory). Negative nominal rates would circumvent entirely the need to run through the marketplace, giving policymakers a direct outlet of financial control/repression.

Of course, given that human nature rarely conforms to these kinds of mathematical and mechanical suppositions, banks nor individuals will not suddenly embrace risk simply because safety now costs more (negative nominal rates on t-bills should spill over into other asset classes in one form or another). Negative nominal rates won’t suddenly fix banking institutions with balance sheets that tilt heavily in favor of sovereign debt that realistically will experience some profound degree of losses. Nor will negative nominal t-bill rates suddenly change lending standards to much more 2005-like levels of irresponsibility. This kind of interest rate policy has absolutely no chance of increasing credit to the real economy. But if such a policy stirs up money velocity as its proponents hope, it will not matter.

However, the first impulse of a system captured and engrossed by risk-aversion to an increase in the cost of safety will be to find other means of expressing those primal desires for it. Rather than respond exactly like the clinical predictions, banks will instead look for a relative substitute (gold is an example of substitute that can both store value and be used as collateral). As demand for a substitute rises, so does the emotional desire to hoard it – the only shift will likely be in the instrument or asset class that gets hoarded. In human systems, actors are often willing to bear penalties when experiencing stark emotions, especially when fear of monetary loss is involved (especially coming so soon after a historic panic, one that never seems to have fully dissipated). So the first attempt at velocity control is about as likely to succeed as quantity of money policies.

Once the explicit negative incentive genie is out of the bottle, the question becomes where policymakers go after the inevitable failure. That is what makes this change so dramatic. We have gone from an era of largely positive economic and financial incentives, or at least where negative incentives were not so explicit, to the possibility of a new epoch where disapproved financial behavior is openly rejected and punished (bans on the short sales of banks and naked credit default swap investing have been instituted previously, but negative nominal rates, again, is taking everything to another level, especially considering that they could affect a much larger proportion of investors, in money market funds perhaps). To say it is a slippery slope would be stating the obvious in a world where the governments now feel they can openly force individuals to buy health insurance.

Given rigid adherence to the equation of exchange, it is probably too much to ask policymakers to at least revise it or their understanding of it. Instead of seeing flaws in their policies and their system (or their oversimplified idea of velocity), they continually act along the same predictable arc. Seeing failure in the quantity of money solution to the real economic and financial problems, there is no rethink of potential policies or basic beliefs. Authorities, entranced by mainstream economics, are trapped in the linear thinking of a science that is not really science. Failure is never a result of poor policy, it is always due to not going far enough. Doubling down is the only solution that appeals to this pattern bias.

So the switch toward explicit negative incentives may signal, in my opinion, a shift to more serious attempts to enforce economic goals through stiffer, more direct means. Again, since success is not a likely possibility given that these incentives do not address any of the underlying concerns that are driving these emotions of fear and uncertainty, the only question is how far policymakers might go. In 1933 the U.S. government went so far as to confiscate all private gold holdings under Executive Order 6102, rationalized at the time as an anti-hoarding salve. And if that was not enough of a kick in the face of individual liberty, the same government almost a year later seriously devalued the dollar – essentially aggregating a good portion of the Great Depression’s losses and socializing them on the very people that were trying to opt out of the system.

For all the historical demonization, hoarders are really doing nothing more than exercising the free will to exit a system. Gold holders in the 1930’s were simply looking to store purchasing power in some method that would not be subject to the failing system’s fractional pyramid inversion. Credit booms always go too far, meaning there has to be losses to someone at some point. Hoarders are simply trying to make sure they’re not the ones holding the bag for others’ heavy mistakes.

That is what makes the idea of negative economic incentives so unappealing to anyone that is not captured by the mainstream economic template. It is yet one more way to socialize losses amongst the body of people that may not have had anything to do with creating said losses. The free market and true capitalism created so much wealth precisely because there was an element of justice and fairness to it (though it has not always been perfect), meaning it had broad, universal appeal. But perhaps more importantly, there was a tangible ingredient of stability to it all because of market discipline. This simple idea is nothing more than people with bad ideas or that make mistakes suffering the consequences for their mistakes. That is reassuring to the marketplace in a way that negative economic incentives can never even hope to be.

We have to look no further than ZIRP itself to see them in action. To date, ZIRP has been an implicit negative incentive regime, creating a hidden tax on savers in favor of the banking system. Generated returns of holding « safe » and short maturity financial assets are artificially held to near zero so the banking system’s cost of funds can be as well, and thus banks’ ability to make money rises dramatically. This transfer of money from savers that have acted responsibly during the crisis to the very actors that initiated it is the opposite of market discipline. Responsible economic actors and their actions are being punished because of the academic economic mainstream canon. Worse yet, banks are given this no-cost method of making money when so many of them should no longer exist simply on the grounds they cannot seem to perform even the basic function of intermediation (it is bad enough they gave us the housing bubble and mortgage bond collapse, they « rectified » it by jumping right into PIIGS).

Despite the now six-year commitment to ZIRP, there is no evidence it has had any positive impact on the real economy (or the banking system for that matter). Credit is still mired in its rightful slump, with the savings rate still higher than the pre-crisis period. Savers have largely refrained from indulging this mathematical attempt at managing « animal spirits » where they are expected to move out of savings to spend, spend, spend. Economists and policymakers may grouse about the supposed fallacy of composition that they seem to see everywhere, but individual actions of self-interest are what make up the economy, not the socialized diktat of the self-empowered.

At the most basic level, negative economic incentives are simply about getting people to do what they do not want to do because policymakers believe themselves more apt and able to make those kinds of decisions for everyone else. That is essentially what the fallacy of composition means, that policymakers know what is best for the economy as a whole, so individual actors be damned since they cannot see the socialized forest from the individual trees. Failure can never be due to policy, only those repellant self interests. So the natural response by economic authorities is to reduce (or eliminate) the ability of individual actors to realize their own interests (in 2009, for example, there was some serious thought, particularly in Europe, given to issuing cash currency with a maturity – meaning you had to spend your money or lose it – to fight supposed deflation).

The same impulse that gave us Executive Order 6102 runs through the impulse that gave us the health insurance mandate: those at the top know what is best for the rest of us, better than we know for ourselves. It is also the same as the inclination that strives to enforce negative economic incentives. That they are now becoming more explicit, rather than hidden, may portend a change in the angle of the slippery slope. Unfortunately for the rest of us, this will lock the system into perpetual crisis since coercion is not an effective way to manage markets (economists really should learn about finance at some point in their lives, see the noticeably rising volatility and correlation across nearly every market). Coercion will lead only to further retrenchment, leading to more intervention and so on. It will only end when authorities stop seeing the economy as a system to be governed and managed, and start seeing it as a way for free participants to freely associate to further their own unique, individual set of interests


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