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Quantitative Easing – Its not Brexit That Will Bring The Next Depression 1st April 2019

QE – What Is It?

Just over a decade ago, the global financial system came very close to collapse after years of excessive debt issuance, over leveraging and greed by banks, governments and the public. In desperation, central banks chose a solution that had been used on a limited scale in previous market downturns, and aggressively in Japan since 2001 . The solution was quantitative easing, or QE. Used by the US (the Fed), and the Bank of England (BoE) and later by the European Central Bank (ECB), while it was reintroduced in Japan. The result was averting the greatest threat of financial collapse the world has seen in living memory. But did it avert the threat or create something more destructive?

The 2008 Financial Crisis

In 2008, many banks and other financial institutions were about to go bust, having amassed substantial levels of debt that had gone bad and no cash reserves to rescue themselves with. Thus, banks were forced to repair their balance sheets and stopped lending, instead aggressively selling, call in loans to their customers as well as those to other banks. The deflationary death spiral with customers going down with their bank, and every bank going down together.

The Bank of England was faced with a choice: allow a deflationary depression; or monetise the debt and create money to neutralise the deflationary forces.

Central Banks To The Rescue

QE was used to buy assets from financial institutions, first government bonds and later, corporate bonds and other assets as well. QE increased demand for bonds, pushing up prices whilst depressing the yield – the rate at which the government borrows money, helping push down other borrowing costs within the economy. In extreme cases such as Bank of America in the U.S. or the UK high street bank RBS, direct capital loans were given to ensure it could remain open for business. The ECB didn’t conduct QE until a few years after the US or the UK, but was no less aggressive in its execution.

  Central banks also co-ordinated an unprecedented global-wide cut in interest rates. Prior to the crisis, the usual way central banks dealt with downturns was to cut interest rates. Coupled with the QE bond purchases pushing yields down, the result is the past decade experiencing the lowest interest rates in recorded history. This means that those who were overborrowed could continue to pay their debts while banks and institutions eventually stopped calling in loans to each other and their customers.


The theory is that by ‘printing’ new money, central banks took bad debt out of the financial system and onto their own balance sheet. Banks and financial institutions saddled with less debt but more cash capital would stop recalling in loans and be more willing to provide new loans, helping to encourage investment and create employment, leading to economic growth and higher tax receipts.

  At the same time, rising asset prices and low interest rates would encourage people to spend more instead of save, contributing to economic growth. Those with assets rising in value feel more confident and thus spend more. By this process, a trickle down effect would boost the economy.

KEY POINTS SO FAR

  • Bank of England prints money to buy bonds from distressed financial institutions.
  • QE increased demand for bonds, pushing up prices whilst depressing the yield – the rate at which the government borrows money.
  • Interest rates were cut to the lowest level in history to spur borrowing and spending.

QE – Whats The Problem With GDP?

QE essentially has gone through a number of phases since it began: three phases of QE, with the BoE buying mostly UK government bonds and later some high rates corporate bonds, three phases of post-QE pause, and one phase of reverse QE – shrinking its balance sheet as a percentage of GDP.

GDP has long been considered the best aggregate measure of economic activity, both in the UK and across the world. GDP figures are often quoted as indicating whether a country is growing and by how much. But on its own, it tells us little about our overall or individual economic welfare. A real growing economy would enjoy a higher GDP relative to the amount of QE that has been used to stimulate the economy, and see greater benefit across the economy like rising wages.

Average Earning Remain Stagnant
Inflation Continues To Rise

Inflation refers to when an economy’s overall price level is rising. The Consumer Price Index [CPI] is a measure of the overall cost of the goods and services bought by consumers. According to the ONS, CPI has been rising in the UK by 2.4% on average each year over the past decade.

In other words, average cost for goods and services have risen cumulatively 28.8% since 2007, whilst wages have remained stagnant. This means the cost of living is higher and when income is less than expenses, money is borrowed to make up the difference.


QE – What Does This Mean?

“The problem with Quantitative Easing is that it works in practice but it doesn’t work in theory”

Ben Bernanke

The problem is that money created by the BoE was used to buy government bonds from the financial markets (financial institutions). Therefore, the money went directly into the financial markets, boosting bond, stocks and property nearly to their highest levels in history instead of going into the real economy through loans to individuals and businesses.

The BoE itself estimates that the first £375 billion of QE led to 1.5-2% growth in GDP. In other words, though QE took £375 billion of new money to create only £23-28 billion extra spending in the real economy.

That’s incredibly ineffective and clear evidence that very little of the money created through QE boosted the real (non-financial) economy.

The result has been asset prices, inflation and the cost of living all increasing whilst interest rates and wages have remained stagnant. This has resulted in increasing levels of debt to bridge the gap. But if true, how much debt and who by?

Combined total debt in the UK has increased nearly 83% since 2007. In other words, debt levels have grown at approximately 8.3% per year, far faster than reported economic growth.


KEY POINTS SO FAR

  • QE was printing money to buy government bonds from financial institutions on the assumption it would spur cash rich institutions to lend more, generating growth and recovery.
  • Slashing interest rates to near 0% made the cost of borrowing cheaper at the expense of savings.
  • Most of the money printed through QE stayed in financial markets, boosting asset prices with little ‘trickling’ down into the real economy to spur real growth.
  • Ten years on, there is little evidence that QE boosted growth in the UK (or elsewhere for that matter).
  • A decade of low interest rates, cheap credit, low growth, stagnant wages and increasing asset prices, has resulted in levels of debt that are now higher than ever before in history.

Is It Just The UK In Trouble?

The BoE was not the only central bank to conduct QE. The US Federal Reserve printed $2 trillion in QE since 2008 and the US economy has seen 2.3% annual GDP growth. Over the same period, the US national debt doubled from $10 trillion to $22 trillion. They began raising interest rates but the US economy is so dependant on cheap-money policies, it cant handle 2% interest rates (the Fed hiked rates from 2.25% to 2.5% last December and stocks have fallen 20%). Europe is even worse. Europe doesn’t have near-zero interest rates, it has negative rates. This means savers effectively pay the banks to hold their cash instead of receiving. And the EU economy is so weak, it cant even handle zero percent rates. It’s STILL printing money under its QE programme.

Ten years on, the largest economy in the world cant raise rates without a crash and the third-largest economy cant keep going unless it continues to print more money and keeps rates negative. Both are struggling with growth and have ever increasing debt burdens. Yet, courtesy of near-zero interest rates, quantitative easing, government stimulus spending and bank bailouts, the crisis was ‘resolved’. According to the Institute for International Finance (IIF), global debt just before the financial crisis in 2008 was ‘only’ $150 trillion. As of 2019, global debt now exceeds $244 trillion.

This leads to providing an explanation why the BoE has kept interest rates near 0%.

The answer is they can’t raise interest rates without bringing a collapse.

The BoE raising interest rates will benefit savers, but will also raise the cost of interest payments on all government, corporate and household debts. It will also make future borrowing more expensive and less appealing. With an economy that is struggling to show real growth, and costs of living higher than take home pay, the risk of defaults from those unable to cover the costs is high.


What Will Happen When The Debt Bubble Pops?

      Everyone understands debt pretty well when it comes to their personal finances. You borrow money, you have to pay it back someday. If you can’t, your creditors hound you until you either come up with the cash, or worst case, you eventually file for bankruptcy, thereby defaulting on your debt. It is as simple as that.

      Yet it seems people seem blithely unaware that the same basic principles apply to countries as well. Most of us tend to think that nations like the UK can’t or wont default on their debt. We aren’t Greece after all. But with our government debt tripling in the past 10 years to £1.8 trillion and stagnant growth, can this assumption still be held?

In our opinion, these conditions mean the financial system is beyond the point where the bubble bursting is all-but-impossible to avoid and cannot lead to anything else than a crisis between now and the early 2020’s. However there are different paths it could take. Here we present the scenarios that the UK is likely to follow:

Scenario 1: Recession 2.0

      Another crash in asset values would affect the collateral of UK banks and because increasing defaults on loans mean losses, the banking sector could again face recession. But this time round, because all the emergency measures adopted by the BoE after 2008 are still in place, there is very little authorities could do to stem the panic. This makes a recession an ominously likely scenario, particularly in the near-term when you consider UK property and stock valuations are near all-time highs and starting to falter, debt levels are at all-time highs, coupled with the uncertainty over a disorderly Brexit.

Scenario 2: Kick The Can Down The Road Until 2020’s

      Could this be averted? Not likely, but it its possible the inevitable could be delayed. The BoE could restart its QE programme for a fourth time or find some other way to push central bank liquidity into the financial markets. QE3 in 2016 came immediately in the wake of the UK voting to leave the EU so the BoE has already proved it is willing to step in on any issue it considers a threat to the UK’s financial stability.

The BoE could also adopt the strategy the ECB has taken and cut interest rates to negative. This would negate the cost of borrowing on existing and future debt but at the expense of savings. As we know from the ECB, this would make the UK completely beholden to QE and make it impossible that the BoE would ever be able to raise rates back above zero. However, whilst I cant ultimately predict the future, in our opinion ,it is unlikely that the Bank of England would be willing, or that they would be allowed to adopt negative interest rates.

Scenario 3: Global Depression

      A decade ago, it was too-easy credit and indebtedness that brought the UK and most of world to its knees. No one back then expected a crash and in the end all it took was for people to suddenly lose confidence in being repaid on money already loaned so they simply stopped lending more. The flow of money and credit is the lifeblood of any economy let alone the global economy, and once it stopped, the financial system ground to a halt.

With global debt nearly doubling since 2008 to $244 trillion, a loss of confidence could see the global financial system grind to a halt once again and affect collateral that all banks hold. Even if central banks around the world try further rounds of QE, what message would that be sending? How likely is it that the public would believe 4th times the charm? If they don’t, then systemic meltdown would likely mean the banking sector would stop, credit cards would cease to function, loans not rolled over and demanded repaid. Global trade would collapse as people would no longer be able to buy anything, and with that the world economy could collapse into the Second Great Depression.


Can You Protect Yourself?

As the UK’s (not to mention the rest of the world’s) financial and monetary systems become increasingly fragile, gold is the ultimate safe haven for protecting you against a systemic collapse. In the inevitable transition that will follow such a collapse, holding ‘real’ assets like Gold and Silver as wealth is the ultimate strategy for survival.

      It acts as a safe haven during periods of economic stress. It has intrinsic value and no liability, unlike stocks and bonds. Currencies (the British pound, US dollar, Euros, etc) are backed by nothing except a promise to pay (I.O.U.) the very definition of a fiat currency. Gold has a limited supply, unlike a government printing press so the value of gold holds up over a long period of time.

The clearest example of this is when Richard Nixon closed the gold exchange system for the US Dollar in 1971, decoupling the last currency in the global financial system from gold.

In 1971, gold was worth $35.08 per troy ounce, so $1,000 USD purchased 28.5 troy ounces of gold. Today, $1000 USD will buy you only 0.76 troy ounces of gold. If someone took that $1000 in 1971 and put it under a mattress, they would still have $1000 today. But if they had purchased 28.5 ounces of gold and put it under the mattress, they would have$37,050 USD today.

For us in the UK, gold in 1971 was worth £16.69 per troy ounce, so £1,000 GBP purchased 59.9 troy ounces of gold. Today, £1000 GBP will buy you only 1 troy ounce. If someone took that £1000 in 1971 and put it under a mattress, they would still have £1000 today. But if they had purchased 59.9 ounces of gold and put it under the mattress, they would have £59,900 GBP today.

      Precious metals are, and for thousands of years have been, the focal point of wealth. Money use to be created with it, central banks use to directly back the amount of paper money they printed with fixed amounts of gold held int their vaults. Central banks still hold gold because the fundamental principle of gold is a long term store of value. Is it any wonder then that over the past decade, numerous central banks around the world have been buying gold more than ever before? Recently, the World Gold Council reported that central bank purchases of Gold in 2018 were the highest they’ve been in 50 years.

      Gold is by no means the only store of value. Assets of intrinsic value like gold, include silver, platinum, and with increasing evidence certain digital assets such as Bitcoin may prove to be the digital equivalent to Gold. Having said that, gold is still the safest and most stable store of value known to man. No other asset class comes close to gold in terms of stability over history. Gold is not an investment per se. Gold is money. Gold is savings. Gold is wealth.

      When the debt bubble finally bursts, your stores of value will become truly priceless assets through whatever transition unfolds.


©EBLN DMCC Ltd 2019

Jonathan Salmon

Jonathan Salmon

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