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If you find yourself in a hole, stop digging!

Do not expect policymakers, including US Fed and Chinese leadership, to admit that they followed a policy of too much stimulus similar to the one that caused the 2008 crash. For them it is simply easier to ignore the risks and keep the money flowing

This week despite the endless fanfare and speculation, we did not see the beginning of tapering by the US Federal Reserve (Fed). The reason that the Fed gave is that the US economy is not strong enough to go without the additional stimulus. This may be true. Job growth in August was lacklustre. The Fed cut its forecast (again!). The US economy is now forecast to grow at no more than 2% this quarter. In addition, the US Congress is totally deadlocked. The effects of the austerity program known as sequestration are beginning to be felt. Without a likely temporary fix, the government will shut down next week and the debt limit may not be raised next month. However, is more money really the answer? Actually no. If all the money pumped into the economy over the past year really had an effect, the economy would now be a lot stronger. The real answer is that the Fed has no idea what to do and is just repeating a failed policy.

 

Nevertheless, do not expect anyone on the Federal Reserve Board of Governors, especially its outgoing Chairman, Ben Bernanke, to admit it. Admitting that they followed a policy of too much stimulus similar to the one that caused the 2008 crash might just destabilize frothy markets. It is simply easier to ignore the risks and keep the money flowing.

 

The first and second round of quantitative easing (QE) seemed to work at least during the program. But when the program ended, so did any gains. The lesson that the Fed seemed to learn is that if some QE is good, endless QE is far better. So they started the third QE. The difference is that they did not state a specific end date. Therefore, in theory the program can go on forever. But nothing does.

 

The third round of QE was similar to the other two. For a time it boosted markets and it seemed to boost the economy a bit. So it was considered a success. But there was a problem. While markets seem to give immediate proof of the program’s potential, the risks take much longer are just beginning to show up. However, the collapse of emerging market currencies at the mention of a slowdown in stimulus showed that risks are definitely there.

 

The US housing bubble had a similar course. The skyrocketing house prices were considered risk free.  Housing prices never went down. So the policy looked tremendously successful in the short term, the real and devastating risks of overpriced homes and bad mortgages took longer to appear.

 

The third round of QE forced investors to take greater risks than they otherwise would have. So money went into far more speculative investments. At the merest hint the program would end, money started to flow out of these investments. An obvious example would be emerging market bonds, but there are many, many others. They come in all shapes and sizes. From pik (payment in kind) and covenant light (cov-lites) loans in the US, to over-burdened consumers in Brazil, Thailand, and Korea, to bubbly housing markets in China and Australia, to rising bad loans everywhere. Whether these risky investments come back to haunt the authors of QE remains to be seen. My guess is that they will perhaps with a vengeance as the weakness of many more debtors all over the world becomes apparent.

 

But the Federal Reserve is hardly alone in repeating a policy with short term benefits, but longer term risks. China’s policy of massive stimulation based on borrowing may have a much greater impact than QE.

 

China built its success by suppressing interest rates and using large savings from a population with few social safety nets to make huge investments in its economy. Over time, this led to a large imbalance in the economy. While consumers spending make up 60% to 70% of most economies, their share of the Chinese economy could be as low as 35%. The state led investments in infrastructure and state owned companies have led to very high levels of inefficiency and over capacity. Much of this investment was funded by a cascade of loans, first from state owned banks and over the past two years by an explosion of the shadow banking system.

 

The Chinese leadership has acknowledged the need for reform. Li Keqiang, the Chinese premier, promised to overhaul state-dominated financial institutions, liberalize interest rates and eventually make the renminbi freely convertible. He has also said that he would rein in the domination of the China’s financial sector by state owned companies. In a recent speech, he also told executives that the government would no longer pour massive amounts of stimulus into the economy. He said, “When the economy is slowing, using a short-term stimulus to boost growth is one method, but we think that doesn't help solve deep-seated problems". 

 

It looked earlier this year when the Chinese economy was slowing that the government was true to its word, but that policy was short lived. When the slowing became uncomfortable, the government went back to the same old policies: more infrastructure spending and new loans to state owned industries and insolvent local governments.

 

In August, China’s industrial output increased 10.4% year-on-year a 17-month high and up from a 9.7% pace a month earlier. The markets assumed that it was a recovery but it was just digging the hole deeper.

 

The biggest rise in output came from state-owned sector. The rest of the rise came from the usual suspects: infrastructure spending and local governments. Total spending on infrastructure projects from wastewater treatment plants to new subway lines approved by the government in recent months reached more than Rmb1trillion ($160 billion). Many projects had already been planned but their implementation was sped up. Local government spending on highways went up 23% compared with a year earlier.

 

Of course, the surge in spending was not fuelled by taxes, but by more debt. Total social financing, China's broadest gauge of lending, surged in August to 1.57 trillion yuan ($256.6 billion) from 808 billion yuan in July. China's total lending has risen to close to 200% of gross domestic product this year, up from around 125% in 2008. But rising debt-to-GDP levels are an indication that much of the lending is not going to build new project but to pay off old loans. Worse, much of the financing was done with riskier short term unsecured financial instruments.  Therefore, the optimistic economic data that gave a boost to markets earlier in September only proves that the structural problems in the Chinese economy have only gotten worse due to the same policies.

 

In 2003, the new governor of Bank of Japan (BoJ), Toshihiko Fukui, doubled the level of quantitative easing. The stock market soared increasing by 65% in a year. But after the initial jump the economy, inflation and stock market went nowhere for 18 months as QE slowed from 2004 to 2005. This time when the new Bank of Japan governor, Haruhiko Kuroda, took over, he again started a round of QE and again the stock market soared. But this time the BoJ tried not to repeat their mistake and followed the American example by allowing unlimited QE. No doubt, they will also find it as difficult to unwind the program as their American colleagues.

 

The is an expression in the US, “If you find yourself in a hole, stop digging”. Sadly, this does not apply to policy makers. They feel if a policy worked well to solve a problem but for only a short period of time, then the solution to solving the problem is to repeat the policy, just larger, which will probably work, for a bit longer, until it doesn’t.

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