Richard Koo



May 17, 2011

QE2 has transformed commodity markets into liquidity-driven markets
As I spoke with investors in London and Geneva last week, markets were rocked by a resurgence of fiscal problems in Greece and a steep drop in the price of silver and other commodities. In London there was talk in the market that the drop in commodity prices had left a handful of investors facing serious losses. If true, it suggests that the preceding rise in commodity prices was driven by speculation and not by real demand. Another frequent topic of discussion was QE2, indicating that many investors established large positions based on the availability of substantial amounts of liquidity under this program. All these factors suggest that a number of markets have been transformed into liquidity-driven markets, and that asset prices in those markets may have risen to levels that cannot be justified by the real economy.

Richard Koo is chief economist at Nomura Research Institute. This is his personal view.

Richard Koo

Two problems with QE2
In the debate surrounding these issues, I was struck by (1) the misconceptions of QE2 held by some market participants and (2) the fundamental problems inherent in QE2. In this report I would like to touch on both of these questions. Turning first to the market’s misconceptions regarding QE2, many investors believe that the large-scale quantitative easing programs implemented by the Federal Reserve and the Bank of England have left the markets awash in money, and that this money is providing substantial support for the real economy and markets. The Fed’s balance sheet is now three times its pre-crisis size, and the Bank of England has taken similar measures. This balance sheet expansion has been the focus of much attention in the markets. When a central bank triples the size of its balance sheet, the amount of liquidity being supplied to the market is also tripled. Under ordinary conditions, that would result in a tripling of the money supply, the key indicator of the money available for use by the private sector. A tripling of the money available for consumption and investment by the private sector puts strong upward pressure on GDP and prices, including asset prices. That is why investors had such high expectations of quantitative easing.

How money supply grows under ordinary conditions
In reality, however, the money supply has betrayed market expectations inasmuch as it has increased only modestly in response to quantitative easing, if at all. To understand the significance of this, we need to understand the relationship between the money supply and central bank-supplied liquidity.

See Appendix A-1 for important disclosures. Analysts employed by non US affiliates are not registered or qualified as research analysts with FINRA in the US.

Nomura | JPN Richard Koo

May 17, 2011

When a central bank provides liquidity to the market, it buys government debt or other securities in exchange for cash. The previous owners of those securities, typically financial institutions, take that money and attempt to turn a profit by loaning it out. If borrowers use the money to buy goods and services, the providers of those goods and services will take the money they receive and deposit it at their banks, leading to an increase in private-sector deposits. Banks receiving those new deposits will increase their lending accordingly. If the new borrowers also use the borrowed money to buy goods and services, the providers will again take the proceeds and deposit them in a bank account, driving further growth in private-sector deposits. Both private-sector deposits and lending continue to increase as this process is repeated. However, banks cannot lend out the entire amount of new deposits because a portion must be set aside as statutory reserves. This creates a leakage in the cycle of increasing deposits and lending equal to the increase in statutory reserves. Consequently, the process of deposit growth will continue until the entire amount of liquidity supplied by the central bank is set aside as reserves. If the statutory reserve ratio is 10%, the deposit growth process will end once the liquidity injected by the central bank has been transformed into deposits worth 10 times the initial amount. The money supply data, composed mostly of bank deposits*, are closely watched by market participants because of their close relationship to GDP and price levels. The numerical relationship between the money supply and the initial liquidity injected by the central bank is called the money multiplier. In the previous example, the multiplier would be 10. *Strictly speaking, the money supply includes bank deposits, currency, and coins.

Money supply has shown little change despite sharp increase in liquidity
What actually happened, however, is quite different. Market liquidity in the US and the UK almost tripled. But the money supply, which represents funds actually available for use by the private sector, has increased little if at all since the financial crisis in 2008. Figure 1 shows the US monetary base (ie liquidity) along with the money supply and commercial bank loans and leases outstanding (ie private-sector credit), rebased so that August 2008 = 100. The graph confirms that these three indicators moved in unison, as the textbooks predict, until the Lehman-inspired financial crisis. Since then, however, liquidity has surged to nearly 300, yet the money supply stands at 115. As explained above, growth in the money supply should entail a corresponding increase in bank lending under ordinary conditions. Yet lending had fallen to 90 by April 2011. In other words, the money supply—which supports consumption and investment—has exhibited little growth during this period. We cannot expect an expansion of the economy or an acceleration of inflation without an increase in the money supply. There is no reason why inflation—apart from imported inflation—should increase at a time when the money supply is not growing. The inflation currently being reported around the world is of the imported variety, typically involving oil and food. “Home-grown” inflation, like the core deflator for personal consumption expenditures shown in the bottom portion of Exhibit 1, remains subdued.

Nomura | JPN Richard Koo

May 17, 2011

Fig. 1: Relationship between monetary indicators breaks down during balance sheet recession (1): US
(08/8 = 100, seasonally adjusted) 300 280 260 240 220 200 180 160 140 120 100 80 % y-y) 3.0 2.5 2.0 1.5 1.0 0.5 08/1 08/4 08/7 08/10 09/1 09/4 09/7 09/10 10/1 10/4 10/7 10/10 11/1 11/4 (yy/m)
Note: Commercial bank loans and leases, adjustments for discontinuities made by Nomura Research Institute. Sources: Board of Governors of the Federal Reserve System, US Department of Commerce

Monetary base Money supply (M2) Loans and leases in bank credit

Down 22%

Consumer spending deflator (core)

Quantitative easing has had no effect in UK, either
An almost identical set of conditions can be observed in the UK. As Exhibit 2 shows, the UK money supply increased from 100 in August 2008 to just 103 in March 2011 despite a near tripling of the liquidity supplied by the Bank of England. Bank lending fell sharply over the same period, from 100 to 86. When the Bank of England announced a bold program of quantitative easing in the spring of 2009, bank officials proclaimed that they would revive the British economy by drastically expanding the money supply and avoiding the policy missteps of Japan. Yet two years later, the BOE’s policies have had no such impact. The pound has also fallen to historic lows on a real effective exchange rate basis, which is leading to higher prices via imported inflation. Home-grown inflation, meanwhile, remains muted, as in the US.

Nomura | JPN Richard Koo

May 17, 2011

Fig. 2: Relationship between monetary indicators breaks down during balance sheet recession (2): UK
(08/8 = 100, seasonally adjusted) 280 265 Reserve balances + notes & coin 250 Money supply (M4) 235 Banking lending (M4) 220 205 190 175 160 145 130 115 100 85 70 % y-y) 6 5 4 3 2 1 0 07/1 07/4 07/7 CPI (ex indirect taxes)


Down 16%
















Note: (1) Reserve balances data are seasonally unadjusted. (2) Money supply and bank lending data exclude intermediate financial institutions. Sources: Bank of England, Office for National Statistics, UK

Reasons for divergence of liquidity supply and 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 the unwillingness of the private sector to borrow. The two factors are rooted in balance sheet problems and are indications that both countries 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 pay down debt and avoid borrowing new money even though interest rates have fallen to zero. Banks, for their part, are not interested in lending to overly indebted companies or individuals, and often have their own balance sheet problems. With no borrowers 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.

Investors still under misconception that greater liquidity automatically leads to money supply growth
Despite this reality, many investors in both the US and the UK appear to labor under the misconception that an increase in the liquidity supply due to quantitative easing will inevitably boost the money supply. Something that many investors have yet to realize is that although central banks in both countries have substantially increased their supply of liquidity, the money available for the private sector to invest or consume—the money supply—has shown negligible growth. In fact, the contraction in private-sector credit in both the US and the UK suggests that the money multiplier may have turned negative at the margins. If so, the two countries should be more concerned about deflation than inflation. When launching QE2, Fed Chairman Ben Bernanke demonstrated an understanding of the conditions described above by stating that—like QE1—it would not increase the money supply (for details, see the 16 November 2010 issue of this report). But

Nomura | JPN Richard Koo

May 17, 2011

many market participants appear to have overlooked this point. I think this represents a major misconception regarding QE2 by private investors.

Government borrowing has supported money supply growth
The question, then, is how to explain the modest growth in the money supply at a time when private-sector credit has steadily contracted. A look at Japan’s experience shows that the answer lies in increased bank lending to the government. As long as the government continues to borrow, banks can continue lending (by buying government bonds) even if the private sector is deleveraging in an attempt to clean up its balance sheet. If the government spends the proceeds of those debt issues, the people on the receiving end of that spending will deposit money with a bank somewhere, leading to an increase in the money supply. In effect, the money supplies of both the US and the UK are being supported by government borrowing. If the two governments chose to embark on fiscal consolidation, their money supplies would contract.

Portfolio rebalancing effect was primary objective of QE2
So what are the actual problems inherent in QE2? Mr. Bernanke has stated from the beginning that QE2 would not lead to an increase in the US money supply. If so, why did the Fed carry out QE2? The simple answer is that it believed QE2 would result in a portfolio rebalancing effect. The portfolio rebalancing effect can be described as follows. When the Fed buys a specific asset (in this case, longer-term Treasury securities), the price of that asset rises. That prompts private investors to re-direct their funds to other assets, which leads to a corresponding increase in the price of those assets. Private-sector sentiment may improve as asset prices rise, and if that prompts businesses and households to spend more money, the economy may improve. In effect, the Fed hopes that quantitative easing will lift the economy via the wealth effect. Inasmuch as the balance sheet recession was triggered by a drop in asset prices, monetary policy that serves to support asset prices may also help pull the economy out of the balance sheet recession.

Unable to buy more government bonds or private-sector debt, investors have few places to turn
In the hope of producing a portfolio rebalancing effect, Chairman Bernanke declared that the Fed would purchase $600bn in longer-term Treasury securities between November 2010 and June 2011. This was roughly equivalent to all expected Treasury debt issuance during this period. From a macroeconomic standpoint, these purchases of government debt meant that—in aggregate—private-sector financial institutions would be unable to increase their purchases of US Treasury securities, because all of the growth in Treasury issuance would be absorbed by the Fed. The fact that US businesses and households were rushing to repair balance sheets by deleveraging meant that—again, viewed in aggregate—private investors would be unable to increase their purchases of private-sector debt. With the private sector no longer borrowing and all new issues of government debt being absorbed by the Fed, US institutions found themselves with few investment options.

So funds found their way to equities and commodities
The only remaining destinations for these funds were equities, commodities, and real estate. Real estate had just been through a bubble and remained characterized by heavy uncertainty. In commercial real estate, for example, banks—at the request of US authorities—are engaging in a policy of “pretend and extend” and offering loans to borrowers whose debt they would never roll over under ordinary circumstances. That means that current prices do not accurately reflect true market prices. Housing prices, meanwhile, resumed falling late in 2010. UK house prices have been falling since mid-2010, and the Halifax House Price Index dropped 1.4% in April 2011 alone (the decline was 3.7% on a y-y basis). The only remaining options for private-sector investors have been stocks and commodities. That, in my opinion, is why both markets have surged since the announcement of QE2.

Nomura | JPN Richard Koo

May 17, 2011

Relationship between asset bubbles and discounted cash flow values
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—ie its discounted cash flow (DCF) value—is defined as the sum of the asset’s future cash flows discounted by an appropriate interest 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 hardly surprising, since they lost money because they ignored DCF values and chased prices higher. 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 the BOE is an indication that market participants do not believe that quantitative easing can raise the DCF value of real estate in those markets.

Question is whether prices lifted by QE2 can be justified by DCF analysis
The question is whether prices that have risen in response to the Fed’s QE2 can be justified by the yardstick of DCF, and whether 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 by DCF 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 are expected to increase at a robust pace going forward. The same is true of commodity prices.

Prices that cannot be justified by DCF analysis are in a bubble
The problem surfaces if people decide that today’s share prices cannot be (conservatively) justified using DCF analysis because of 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 to sell 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.

End to new bubbles would further exacerbate balance sheet recession
Viewed objectively, the central banks are trying to push up asset prices using quantitative easing and the portfolio rebalancing effect. The resultant rise in asset prices based on this effect represented a potential bubble—or at least a liquidity-driven event—from the start. The question is whether the real economy can keep pace with asset prices formed in those liquidity-driven markets. If it cannot, higher asset prices will be considered a bubble and will collapse at some point. The resulting situation could be much more severe than if quantitative easing had never been implemented to begin with. In other words, if stock and commodity prices are in fact in a bubble and if those bubbles were to collapse, the balance sheets of the financial institutions and hedge funds making investments with the expectation of higher asset prices could suffer heavy damage, exacerbating the balance sheet recession in the broader economy.

QE2 was Bernanke’s big gamble
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 was a gamble in the sense that the Fed tried to raise share prices with QE2. If the wealth effect resulting from those higher prices led to improvements in the economy, the higher asset prices would ultimately be supported by higher real demand, thereby demonstrating 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 it is 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 totally oblivious to DCF values. But with market participants paying close attention to DCF values, any delay in the economic recovery will naturally bring about a correction in market prices, thereby causing the portfolio rebalancing effect to disappear.

Nomura | JPN Richard Koo

May 17, 2011

DCF analysis is still dependent on human judgment, and there is no guarantee that all analysts will come to the same conclusion. For instance, former Fed Chairman Alan Greenspan repeatedly argued that housing prices had not diverged significantly from DCF values at a time when the US was in the midst of its biggest housing bubble ever. The Economist magazine in the UK, meanwhile, argued that US housing prices had diverged substantially from DCF prices and called a bubble. In the end, it was the Economist whose calculations were correct.

We must not put excessive faith in recovery supported by fiscal stimulus
Recent growth in the US economy also presents a danger in that it is making people complacent. Relatively strong economic indicators—data showing the economy created more than 200,000 jobs in the latest month for which data are available—have encouraged talk of fiscal consolidation. But the economy is far from achieving a self-sustaining recovery. As indicated in the discussion of the money supply above, private-sector credit is not only not expanding but continues to shrink. That the money supply and GDP are still posting modest growth is only because the government continues to borrow and spend. This is identical to the phenomenon observed in the US in 1933–36 and in Japan after the collapse of the Heisei bubble. In other words, the US economy is being supported solely by massive fiscal stimulus amounting to 9% of GDP. It is not growing because of the efforts of the private sector.

Japanese government in 1997 overlooked economy’s reliance on government spending
The reason why government officials and economists decided that Japan was ready for fiscal consolidation in 1997 was that in 1996, the year before the policy was implemented, Japan posted GDP growth of 4.4%, the highest of any G7 nation. In reality, however, most of that 4.4% growth was made possible by government support in the form of fiscal stimulus worth 5% of GDP. Once that support was removed in 1997, the Japanese economy fell off a cliff and experienced five consecutive quarters of negative growth. The US and UK economies and money supplies are currently being supported by fiscal stimulus totaling 9–10% of GDP, far larger than the Japanese stimulus in 1997. The deflationary impact could be severe if these supports were removed. At the very least, the continued decline in private-sector credit is evidence that the two economies are not being supported by growth in private-sector credit.

Roosevelt made same mistake in 1937
This pattern of expansion in the money supply and the economy despite an absence of private-sector credit growth was also observed in 1933–36 as the US economy emerged from the Great Depression. President Franklin D. Roosevelt was unaware of the importance of this relationship and, believing that the economy was already on a self-sustaining growth path, embarked on a path of fiscal consolidation in 1937. The US economy consequently fell into a severe recession characterized by sharply lower production and drastically higher unemployment. It took the Japanese attack on Pearl Harbor for the US economy to recover from the resulting damage.

Central bank and government policy at odds in US and UK
Whereas the Fed and the Bank of England hope that the portfolio rebalancing effect of quantitative easing will boost the economy and lift the DCF value of assets, governments in the two nations have come out in favor of fiscal consolidation, which would depress both the economy and the DCF value of assets. Fed Chairman Ben Bernanke continues to argue that now is not the time for fiscal consolidation. BOE Governor Mervyn King, meanwhile, is arguing that more fiscal austerity is needed. I think it is important that we keep a close eye on the level of asset prices that can be justified on a DCF basis (1) in the current moderate-growth economy and (2) in the event that fiscal consolidation puts the brakes on economic growth.

Richard Koo’s next article is scheduled for release on 31 May 2011.

Nomura | JPN Richard Koo

May 17, 2011

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