QE: A Sedative That Robs The Economy of Vitality

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I have seen the mess in Cyprus compared to the old joke about shooting birds on a branch. Someone might inquire how many birds are left on a branch after you shoot one. The ultimate answer, the incorporated home-spun wisdom, is that none will remain no matter how many were there initially. So it goes with depositors. You tax or install a levy on one, and the fear rises such that no depositors remain.

Where that fear gets dangerously interesting is that it is true for not just individual depositors within a single, contained banking system, but for the whole class under a quasi-single political entity. Metaphorically shoot depositors in Cypress, without any real legal authority, and those in Spain, Greece, and Portugal start to feel like remaining on the euro-branch isn't the best course for continued financial existence (or in the case of PIIGS depositors, subsistence).

We will not know until Tuesday, at the earliest since the now week-long bank holiday continues to stretch further into the future, just how many birds will be left sitting on the Cypress branch. There is no doubt, however, that the fear is real not only among the Cypriots caught in this mess, but also within the offices and counsels of European policymakers. There is real potential here for something far worse.

In terms of analogies, though, the bird/branch dynamic fits to a certain emotional response of imminent danger. But that works only insofar as that danger is a singular impulse, not repeated or persistent. The European problem remains an unsolved problem going on four years. The ebbs and flows can be marked in the financial "markets" for many assets and securities, from Spanish stocks to Danish sovereigns to Swiss francs.

In the medical field, surgery in particular, there is a phenomenon called anesthesia awareness. Estimates vary, but between one and two surgery patients per 1,000 wake up briefly after being sedated by general anesthesia. These unfortunate victims wake up feeling paralyzed or incapacitated physically, can experience intense pain and can be scarred emotionally.

Most market observers compare monetary policies' impact on asset markets to heroin or cocaine, as if investors only react and markets only rise when they get their central bank "fix." To me, however, central bank monetary policy is anesthesia, applied with the specific intent to put investors to sleep so that they remain unaware as to what is going on around them and, most importantly, what is ultimately being done to them. The case of Cyprus is the financial equivalent of anesthesia awareness.

If you looked at a chart of the Swiss National Bank's holdings of foreign currency, what is obvious are three distinct episodes where the Swiss central bank is outright buying foreign currency in large quantities. They have done so in the past few years as a means to control the after effects of the real "flight to safety" into the franc. Beginning in February 2010, the SNB holdings of foreign currency jump from CHF93.8 billion to CHF238 billion in just four months' time. Not coincidentally, the first flare of Greek bond paralysis occurred during that same period.

On May 10, 2010, the ECB introduced its first major intervention in the sovereign crisis - one that was roundly accepted by economists and experts as a real solution. The first Securities Market Program (SMP) would "ensure depth and liquidity in those market segments which are dysfunctional." It sounds like a medical textbook description of anesthesia application.

Anesthesia by itself has no value in strictly medical terms since an application of anesthesia must be accompanied by some invasive means of correcting a physical dysfunction. In this context of the ECB and the European economy, the 2010 SMP was the anesthesia applied in order to perform the "corrective" surgery of labor and wage competitiveness adjustments to the Greek economy. The Greek economy would have to suffer to regain an economic footing with the Eurozone.

But that is not quite the right description - it isn't the Eurozone that is the proximate cause of the economic damage on the Continent, it is the euro-zone; the currency zone. Either the euro would cease as it had been, or "surgery" was needed on the European markets and economies; thus anesthesia had to be applied. The most ready form of the sedative was the old monetarist scheme of manipulating asset prices. What appears to some as an addict's "high" is really a sedation against the realization that dysfunction is serious and potentially worse. In other words, prices (sedative) are divorced intentionally from true value (disease).

The original SMP soothed and sedated markets for more than a year. Swiss holdings of foreign currency fell to CHF188 billion by July 2011. During that time, ECB and political policymakers felt the anesthesia was enough to warrant further invasive action. Soon it would be Portugal, then Spain and Italy that were further candidates for economic adjustments.

During the middle of summer 2011, a second episode of anesthesia awareness shot pain throughout the sedated body of investor perceptions. SNB holdings of foreign currency rose by CHF100 billion in August 2011 alone. The term contagion was everywhere as fears rose that the banking system was not reflecting the true scale of economic dislocation. In other words, prices did not reflect value (reality).

The ECB eventually responded with the LTRO's (after political leaders dithered with various alphabetical combinations of funding schemes, like the EFSF), an influx of almost a trillion euros were created and sent out into the banks as a hefty dose of anesthetic that was assumed to be longer lasting. In the shorter-term, it worked again, as our proxy for anesthetic efficacy, the SNB holdings of foreign currency, fell back to CHF247 billion by April 2012. Market prices improved throughout the continent as investors again decayed into a state of price-driven sedation.

I believe it was 2012 where the anesthesia analogy fits best, because during that year the economic situation across Europe turned from tepid recovery to outright contraction. It was a dislocation that no economist, including those at the ECB, IMF and any number of policymaking institutions, saw coming. And it got progressively worse throughout the year, disproportionately striking those regions where monetary policy (anesthesia) application was most concentrated.

It so happens that in April 2012, the ECB, again confident in its monetary efficacy, began reporting actual usage of the Emergency Lending Assistance program on a separate line in its statements (rather than lumping it together with "other claims on euro-area credit institutions denominated in euros"). This accounting change arose out of persistent questions surrounding Irish banks and how much support the Irish central bank might be covertly forwarding.

The ELA was set up as a "last resort" of sorts for banks that could not find enough acceptable collateral to even participate in the watered-down regimes of the LTRO's. Because the collateral presented under this program was low-quality, the ECB itself did not want to retain credit risk in conducting the program, thus the ELA's were run directly through the national central banks (NCB) themselves. That allowed ELA usage to remain a hidden part of the ECB's often-arcane accounting.

A high degree of ELA usage would indicate, without ambiguity, that the European banking system was still in dire condition. As a result of reclassifying ELA levels to a single line, there was some real shock that €121 billion in hidden "bailouts" suddenly appeared. What's more, that hidden last-resort liquidity was traced back to banks in Spain (mostly) and Portugal, not just Greece and Ireland.

From that moment forward the anesthesia awareness syndrome returned, and the intense pain felt by the markets was worse than the previous instance. Spanish deposits fled, sovereign "safety" markets, such as German and Danish bonds, were over-bid often leading to negative yields as far down the curve as seven years! In Switzerland, SNB holdings of foreign currency went parabolic, leaping from CHF247 billion to CHF430 billion by September 2012.

These bank "jogs" and desperate currency hedges once again largely dissipated once the ECB (and the Fed) promised more anesthesia that September. For its part, the ECB committed to an open-ended OMT or SMP (or whatever they want to call it now), the third or fourth definitive solution in this sorry series.

Yet, for all this trouble and contrary to all accepted, orthodox expectations, the Eurozone remains an economic disaster, but at least asset prices are "encouraging." One only has to look at the PMI surveys and construction and industrial production figures just this week to see that Europe is still sinking into further depression, not emerging into a new age of prosperity. It only goes on as it does because the investor class is asleep under the cozy sedation of monetary policy, blissfully unaware of the dramatic economic carnage that continues to be visited in exactly those places monetary surgery is supposed to "cure."

That is, at least until another episode of anesthesia awareness. The utter lack of tactful approach in Cyprus last Friday is very much like the hubris the ECB showed in its ELA disclosures less than a year ago. And like then, the promises of monetary efficacy prove little to defer rising discomfort bordering on rational fear. Monetarists use asset prices as justification for their own confidence, as if prices were the ultimate arbiter of success, when in fact it is asset prices that are most susceptible to monetarist justifications. It is a peculiar circular logic that pervades the entire edifice.

In point of fact, this is not strictly a European trait. Federal Reserve Chairman Ben Bernanke was actually asked in his press conference Wednesday if there was still time to "get in" the U.S. stock market (new highs and all). That makes a pretty stark juxtaposition with corporate results and economic conditions currently. The U.S. economy is a mess, but asset prices apparently are the way only in which we are supposed to judge.

Asset bubbles have that effect. So many otherwise reasonable people take liquidity as a signal of health. Yet the repeated crisis, the repeated problems of anesthesia awareness and all, belie that interpretation. Every time we see honesty and at least some clarity out of Europe it has the potential to destroy the euro. That says far more about the health of the euro than asset prices ever could. What is more real, the inability of Cyprus' banking system to exist without outright theft or the ECB's promise to change a number on its computerized balance sheet accounting software?

Monetary policy is an illusion. It is cheaply purchased with pleasing emotions that come off like a "high," but it does not nor cannot substitute for real solutions. The housing bubble in the United States was almost universally accepted at the time as a near Golden Age of monetary management. Sure, there were questions about how a stock bubble came about, but the Federal Reserve was largely lauded for navigating such a potentially disastrous period with little apparent damage - because mortgage finance innovation, moneyed by interest rate targeting and wholesale shadow money, was the most powerful anesthesia ever invented. It did not matter that wages, especially adjusted for inflation, were stagnant at best and corporate investment was trending toward financial rather than productive. Such an economic shortfall was forgotten in the sedation of widespread cheap credit and an economy more concerned with consumption than capital creation.

In the end, no matter how you want to analogize or frame this process, central banks cannot under any circumstances create value. Federal Express, another news item this week, is grounding planes and reducing capacity because businesses in Asia are shipping less and businesses in the United States are using "lower margin" services (ie, cutting shipping costs). Is perpetual QE a realistic answer to these concerns? QE is the monetary equivalent of the economic adjustments taking place in PIIGS nations. It is a gutting and hollowing of the productive sectors in the name of finance, robbing vitality from the real economy. Nations are left impoverished where it is applied, but nobody cares while it happens because it feels so very pleasant and sedate.

For its part, FedEx is doing exactly what Chairman Bernanke wants to see. The company is seeing a reduction in earnings growth, reducing headcount, cutting capital expenditures, but, in a manner consistent with the asset price focus, massively increasing its stock repurchase plans. Less capital, more money.

Whether you want to classify them as illusionists, anesthesiologists or just plain dope dealers, central banks have no answers, only the ability to coax your fears to sleep, hidden beyond the cloudy dreams of seemingly perpetual bull markets. Then they can get to work on you.


Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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