Monetary Policy is as Dangerous as a Yanagiba - Article 2

Monetary policy is dangerous, very dangerous. Monetary action is not.

The roots of the sluggish economic growth in the past 10 years, and the lackluster financial stimuli we are witnessing today, go back to the days of Mr Alan Greenspan (US Federal Reserve Chairman 1987 to 2006)

Mr Greenspan, wanting to help boost US growth, started a new wave of monetary policy changes. These included: 

Approved bank consolidation, pushed financial deregulation, advocated a reduction in bank capital reserves and blocked efforts to stop abusive subprime lending.

What does all this mean?

Bank consolidation: allowing banks to merge with each other. This means creating large banks that have the ability to control the market and lobby in a more impactful way for whatever maximizes their profits

Pushed financial deregulation: basically this means reducing the number of traffic lights and speed limits. The analogy here, is that if you are a supercar driver, you would rejoice if the government removed as many speed limits as possible, and reduced the number of traffic lights. This means you can go as fast as you would like, without having to stop. The consolidated banks have become Super Banks, and in order to maximize profits (go fast), they needed financial regulators to reduce, and even remove, some financial regulations that hinder them from “going fast”

Advocated a reduction in bank capital reserves: Ah, I love this one! What does Investopedia say about minimum capital reserves:

“Banks loan funds to customers based on a fraction of the cash they have on hand. The government makes one requirement of them in exchange for this ability: keep a certain amount of deposits on hand to cover possible withdrawals. This amount is called the reserve requirement, and it is the rate that banks must keep in reserve and are not allowed to lend.”

So let us take an imaginary example, if you deposit $1000 USD at the bank, and if the reserve requirement is 10%, your bank has to keep $100 USD, in case you come and ask for a withdrawal, and $900 USD can be used to give loans to other bank clients, whom you do not know, so they can buy a car, an apartment or go for a skiing trip in Verbier. Let us say that the bank has given your $900 USD to Mickey Mouse as a personal loan, and Mickey Mouse deposits the $900 USD at his own bank, then his bank has to keep $90 as minimum reserves (10%), and can give a loan to Donald Duck for the amount of $810 USD, who also deposits it at his bank. As you can see, your $1000 has magically multiplied! Thanks to your $1000 USD, now Mickey and Donald’s accounts show a combined balance of $1710 ($900+$810)! Amazing isn’t it. This is called the fractional banking system, and the above continues on and on. So when Mr Greenspan wanted to reduce the minimum capital reserves (lowering the 10% in my example above), this led to banks having to keep less money as reserves, and can lend out more to avid borrowers. Yes, the more the merrier right?

Blocked efforts to stop abusive subprime lending: This is another great one. What does Investopedia has to say about subprime loans:

“A subprime loan is a type of loan offered at a rate above prime to individuals who do not qualify for prime-rate loans. Quite often subprime borrowers have been turned down by traditional lenders because of their low credit ratings or other factors that suggest they have a reasonable chance of defaulting on the debt repayment.”

So basically these are loans to people who are in a difficult financial situation, who potentially have defaulted on loans previously, therefore high risk borrowers that Mr Greenspan wanted to have them get more loans, by relaxing due diligence requirements made by lenders on these borrowers

I hope you are starting to get the picture, otherwise, please give the above another read.

The story doesn’t stop there. Let us go back to the first bank in my example, who lent out your 900$. This bank cannot lend any more money unless it receives new deposits because it lent out the maximum amount it can out of your deposits, right? Think again, it can thanks to structured credit and a magical instrument called Collateralized Debt Obligation (CDO). So the bank would take your loan that is earning an interest to the bank, along with the loans of other customers, they put them in a box (the CDO) that generates all the interest rates paid by all the borrowers, and they sell this box to an institutional investor. This is an investor who is happy to “buy” this box to earn the interest paid by yourself and other borrowers by the banks. This operation involves work done by investment banks, lawyers, advisors, asset managers, etc, who all earn a fee against producing and managing this complex financial instrument. The result is also magical: your bank would receive fresh cash against selling these loans to a third party investor, hence freeing its balance sheet, therefore will be able to lend more money to eager borrowers. Also, why would the bank have a very strict selection process of borrowers, as long it will sell these loans in a box (the CDO) to a third party investor? After all, if borrowers defaulted on their loans, the buyer of the box (the CDO woud lose money) and not the bank.

As you might imagine, when a normal economic slowdown happens, the first borrowers to default on their loan payments are the subprime borrowers. When they default, the CDOs that contain these loans earn less money to the investor who bought them from your bank, and then KABOOM! This is what happened in 2008, in a simplified way.

The following graph is a summary of the US total debt situation compared to GDP, and what would it have been had certain presidents balanced their budgets.

Why do I have a problem with this?

Monetary policy is supposed to be precise, surgical, very carefully used in the hands of a stable experienced person, who has no vested or political interest. Just like a Yanagiba knife in the hands of a proud Japanese chef. The chef’s only purpose is to produce to you a perfect sushi piece that he himself will not taste or benefit from. His pride and joy is not the payment you will make, but your enjoyment of his perfect piece of sushi (people who went to traditional sushi places in Japan will see what I mean). This chef has no agenda or personal interests, otherwise he would use his Yanagiba in a reckless way to produce a lot of imperfect sushi pieces. Monetary policy when used wildly and erratically to boost growth for political reasons leads to what we are in today.

Furthermore, lenders (mainly banks) have to take responsibility for doing costly and extensive due diligence on borrowers to avoid bad loans, even if these loans will not be on their balance sheet after they are packaged and sold off to other investors.

This system I described in my example above has created compulsive consumers (both individuals and companies) who are addicted to borrowing rather than creating. It has created lazy entrepreneurs with easy and cheap access to capital, because central banks had to lower interest rates to boost the economic growth they helped destroy as instruments of political agendas. Cheap credit is like offering a drug addict cheap drugs. The addict will become more and more addicted and will consume more and more of this drug.

So where are we today? 

“Since 2000, the world economy has grown from US$33.5 trillion to about US$80 trillion, but to achieve that growth, the total debt has grown to over US$247 trillion as of the third quarter of 2018, according to the Institute of International Finance. In other words, it has taken approximately $185 trillion of global debt to achieve $46 trillion of global growth.If we stopped adding to that debt and started to pay it back at a rate of $1,000 per second, it would take nearly 8,000 years.” -“The Price of Tomorrow”, Jeff Booth (credit goes to Nassif Bejjani for finding this quote)

All this is not US centric. Most of the world has fallen into the debt trap to boost growth. The below graph shows this sad reality. All the curves you see dropping in 2010 have all gone up substantially today

Yes, most of our economic growth has come from debt, pushing the can forward, postponing the problem and throwing it into our children’s laps. We have become very creative at producing ways to lend and borrow money, rather than work on what makes us advance as humans.

When entrepreneurs, unemployed persons and people faced with adversity do not have access to this "drug" (cheap money to borrow), and when companies cannot borrow so cheaply, they become innovators. They try to find solutions, create products and services to generate cash instead of cheaply borrowing it. Cheap and easy borrowing contributes to making us lazy rather than creative. Borrowing is essential for a well functioning economy, but not when it is COMMODITIZED.

Modern politics, due to the decay of Power (Moisés Naím), is fundamentally killing creativity and innovation in a disguised way, while cosmetically taking action to support it. The political decay of Power is leading to the decay of the economic foundations of this world. Like all foundations, there is a need for reform, even if not popular with electors. The solution is not to keep voters happy by providing them with cheap debt because one day the tide will turn..

Disclosure: When I was a portfolio manager in Europe, I used to manage CDOs. I believed they were great instruments that allowed for more lending, hence more economic growth. I was wrong.

Further readings and sources:

https://www.ukessays.com/essays/economics/alan-greenspans-role-financial-8864.php#:~:text=Greenspan%20approved%20bank%20consolidation%2C%20pushed,subprime%20lending%20(Pearlstein%202013).

https://www.nytimes.com/2008/10/24/business/economy/24panel.html