I would like to take it a step further, though. What happens to all the bonds that central banks have purchased? We hear an increasing number of both economists and pundits suggest that this is good news because it effectively reduces government debt, now that the debt has moved from private holders to the central bank. Indeed, we have seen reports that Japan may soon have one of the lowest government debt levels as a percentage of Gross Domestic Product (GDP) given that the Bank of Japan (BoJ) owns an ever-increasing share of Japanese Government Bonds (JGBs). If true, this would be the best free lunch ever served in financial history. Sadly, I very much doubt that this free lunch is digestible. Let me give you two arguments:
First, for purposes of analyzing the impact on an economy, we believe the balance sheet of central banks should be consolidated with that of their government. When the Fed, BoJ or other central banks buys bonds, all they really do is replace long-term obligations (buying bonds) with short-term obligations (cash); that is, they reduce the duration of outstanding government debt. So while the Treasury Department in recent years has diligently tried to take advantage of low rates by extending the average duration of U.S. debt, the Fed has (more than) neutralized their efforts by gobbling up bonds. Think about having a homeowner switch their long-term fixed-rate mortgage to an adjustable rate mortgage. This may work well as long as rates are low, but can cause havoc should rates rise. Importantly, since the central bank sets the rates, it provides an incentive to keep rates lower for longer, potentially causing unintended consequences.
Second, and we have eluded to it, when a central bank buys bonds, it not only increases the assets on its balance sheet, but double entry accounting requires that something also increases on the liability side of the central bank's balance sheet. What increases are reserves, notably excess reserves held by banks. That is, banks are sitting on a pile of cash that can be used to support bank lending (as a result of fractional reserve money creation). If there were sufficient demand in the economy, this may provide substantial inflationary fuel. This is one of the reasons we are in 'unchartered' territory. The Fed suggests it can conduct monetary policy through what it calls reverse repurchase agreements, notably by engaging in short-term market operations to reduce liquidity. Our concern is not with the mechanism itself, but foremost the potential political fallout, as they amount to the Fed paying potentially tens, if not hundreds of billions to financial institutions to incentivize them not to use their reserves to provide loans: an increase in interest rates by the Fed directly translates to the Fed paying, well, interest on its liabilities.
The more sustainable approach, in our assessment, would be to unwind QE, i.e. to let the Fed's bond portfolio roll off or possibly sell its bond portfolio. The Fed could also extricate itself by swapping its bond portfolio with the Treasury department for cash or short-term Treasuries, to allow it to return to more traditional monetary policy faster. Selling bonds on a large-scale may well put downward pressure on bond prices, increasing bond yields, i.e. the cost of borrowing for the government, corporations and consumers alike. And that, in turn, might make government debt levels appear less sustainable, as it would signal a sharp reversal from the seemingly ever lower borrowing costs despite higher absolute levels of government debt.
How it will all end?
Higher borrowing costs are a problem if you have too much debt relative to your income. Governments have a couple of choices, including:
• Cutting expenditures
• Raising revenue
• Economic growth that lowers the debt as a percentage of GDP
Cutting expenditures may include things like:
• Reducing entitlement benefits
• Reducing military spending
• Restructuring (defaulting on) debt
We believe different countries will address these challenges differently; some in potentially increasingly creative or convoluted ways to provide the appearance of legitimacy. In practice, the tough decisions may well need to be imposed by the market, whereas policy makers may increasingly focus on hoping that fiscal spending will get us out of the lackluster growth. Unfortunately I can't help but think of how the Great Depression ended: it was a boost of fiscal spending, all right: the financing of a war. I'm not suggesting any one country will necessarily start a war, but do note that increasing military expenditures in the name of national defense may be more easily passed through the legislature in countries without strong majorities than infrastructure spending. Add to that a rise in populist politicians throughout the world, and we have a mix that suggests to me history may well repeat to those unwilling to learn from it.
I leave it up to the reader to decide whether the Fed and other central banks are part of the problem or the solution. However, I would like to caution that investors may not want to rely on the Fed or the government to take care of their financial well being; they have their own problems cut out for them, as a government in debt may well have their own priorities that run counter to investor interests.
Axel Merk is president and chief investment officer of Merk Investments.