None of this will be new to regular readers, but Richard Koo’s latest research note is a nice summary of why QE2 has failed and why it was always destined to fail. Koo talks about how QE2 had no fundamental impact on the money supply, the real economy and helped only to create a speculative mania in many assets. In fact, the whole piece looks like research I wrote 6 months which makes sense since Koo and I have been on the same page since day 1 with regards to QE.
Koo details how the US and UK money supplies have failed to rise with the central bank’s balance sheets and why this is a failure of the money multiplier. Of course, regular readers understand that banks never lend reserves and that the money multiplier is a myth. Therefore, it’s easy to comprehend why we’re seeing no surge in the money supply:
“The decline in private-sector credit in the US and the UK is attributable to both the unwillingness of banks to lend and theunwillingness of the private sector to borrow. The two factors are rooted in balance sheet problems and are indications that bothcountries remain in balance sheet recessions.
When a bubble collapses, the value of assets drops, leaving only the corresponding liabilities on the balance sheets of businesses and households. To fix their “underwater” balance sheets, companies and individuals do whatever they can to paydown debt and avoid borrowing new money even though interest rates have fallen to zero. Banks, for their part, are notinterested in lending to overly indebted companies or individuals, and often have their own balance sheet problems. With noborrowers or lenders, the deposit-growth process described above stops functioning altogether.
US banks now appear slightly more willing to lend money, although that is not the case in the UK. In neither country, however,are there any signs of greater willingness to borrow among businesses and households.”
He goes on to argue that QE2 only generated a portfolio rebalancing effect. But Koo, rightly argues that this is only justified if the assets rise in accordance with their real underlying fundamentals:
“While this may demonstrate the portfolio rebalancing effect of QE2, the real problems are yet to come. Asset prices, after all,are supposed to be determined by the future cash flows generated by the asset. More specifically, the fair value of an asset—ieits discounted cash flow (DCF) value—is defined as the sum of the asset’s future cash flows discounted by an appropriateinterest rate.
A bubble is defined as a situation in which asset prices rise to levels far in excess of their DCF values.
In the immediate aftermath of a burst bubble, investors tend to pay extremely close attention to DCF analysis. That is hardlysurprising, since they lost money because they ignored DCF values and chased prices higher.”
So, do the current market conditions justify their increases since QE2? Koo is skeptical:
“The fact that real estate prices in the US and the UK have continued to fall in spite of quantitative easing by the Fed and theBOE is an indication that market participants do not believe that quantitative easing can raise the DCF value of real estate inthose markets.
The question is whether prices that have risen in response to the Fed’s QE2 can be justified by the yardstick of DCF, andwhether commodity prices that rose following QE2 can be justified in terms of real demand.
There is nothing to worry about if market participants have concluded that equity prices are in a range that can be justified byDCF analysis. But for that to be the case, corresponding growth in the economy and corporate profits are required.
In other words, current share prices can be justified using the yardstick of DCF analysis if both GDP and corporate profits areexpected to increase at a robust pace going forward. The same is true of commodity prices.”
The problem surfaces if people decide that today’s share prices cannot be (conservatively) justified using DCF analysis becauseof factors such as persistent high unemployment, falling housing prices, and sluggish money supply growth.
That would suggest that share prices and commodity prices are in a QE2-driven bubble and that now may be an opportunity tosell assets that have been lifted higher by QE2.
Given that policy rates are already at zero, leaving no room for further rate cuts, and that fiscal policy in the US and the UK is headed in the direction of austerity, which would impact negatively on the economy, there is little prospect of policy support for an increase in DCF values, either.
Koo concludes that the policy had no real economic impact and has been nothing more than a huge gamble. He says there is now a real risk that asset prices could correct downward to meet their true valuations:
“When the situation is viewed in this light, we come to the realization that Mr. Bernanke’s QE2 was in fact a major gamble. It wasa gamble in the sense that the Fed tried to raise share prices with QE2. If the wealth effect resulting from those higher prices ledto improvements in the economy, the higher asset prices would ultimately be supported by higher real demand, therebydemonstrating that prices were not in a bubble.
However, I cannot help but feel that the portfolio rebalancing argument was putting the cart before the horse, in the sense that itis ordinarily a stronger real economy that leads to higher asset prices, and not the other way around.
It might be possible to sustain the portfolio rebalancing effect for some time if conditions were such that investors were totallyoblivious to DCF values. But with market participants paying close attention to DCF values, any delay in the economic recoverywill naturally bring about a correction in market prices, thereby causing the portfolio rebalancing effect to disappear.”
You can read the full piece at Zero Hedge.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.
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