Paul Hodges: Quantitative easing could become the next sub-prime


Sub-prime created the market disaster of 2008/9 and I can see QE having a similar effect and soon.

Central bankers have been like generals in the past few years, focusing all their energies on fighting the last war. Ben Bernanke’s famous “apology” to Milton Friedman in 2002, was just one early indication of their approach: “Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”

Since then, they have based their programmes on outdated and unreliable theories from former gurus such as Milton Friedman and Franco Modigliani:

  • Friedman didn’t realise that a Baby Boom was taking place when he developed his theory that “inflation is always and everywhere a monetary phenomenon”. He therefore confused cause and effect, as hindsight tells us it was clearly excess demand from the young Boomers – when supply was literally “bombed-out” after World War 2 – that caused the inflationary problems of the 1960s/1970s
  • Modigliani’s lifecycle consumption theory was similarly flawed.  His view that people would even out their consumption in the best possible manner over their lifetimes appeared to make sense in the 1950s, when most people died before or close to pension age. But it makes no sense at all when 65-year-old Western pensioners now have 20 years of unexpected life expectancy ahead of them

Both Friedman and Modigliani can be forgiven their mistakes, as there was no reliable data at the time they were working, to explain the errors in their thinking.  But today’s central bankers have no such excuse. Western fertility rates have been below the replacement level of 2.1 babies/couple since 1970 – making it obvious that spending and hence economic growth would slow, and then probably decline, as the Boomers moved into retirement. And slowing demand would automatically reduce inflation, no matter what they did to the monetary supply.

Investors have chosen to ignore these factors until recently. Instead they have taken advantage of the free cash available from central banks to boost the prices of financial assets – whether these were commodities such as oil and copper, houses or stocks and shares. But all good things come to an end. And instead, they are becoming unpleasantly aware that if central banks really don’t know what is happening in the real economy, then populist solutions provided by Donald Trump or Brexit leaders may end up causing chaos in their markets.

The problem has been well summarised by William White, who correctly forecast the 2008 subprime crash whilst chief economist at the Bank for International Settlements, the central bankers’ bank. Now with the OECD, he warned at Davos earlier this year that the failure of QE means that the world will have to revive the Old Testament concept of “debt jubilees“, with much of today’s debt being written off:

“Debts have continued to build up over the last eight years and they have reached such levels in every part of the world that they have become a potent cause for mischief. Emerging markets were part of the solution after the Lehman crisis. Now they are part of the problem, too.

“It will become obvious in the next recession that many of these debts will never be serviced or repaid, and this will be uncomfortable for a lot of people who think they own assets that are worth something. The only question is whether we are able to look reality in the eye and face what is coming in an orderly fashion, or whether it will be disorderly”

Five-thousand years ago the ancient Sumerians and Babylonians recognised that debt grows exponentially and much faster than the real economy. Though painful for some individuals, the forgiveness of debts was seen as the optimum solution for the economy.

It may be a mistake to fight the last war, but that does not mean history cannot still teach us useful things.

Paul Hodges is chief strategist at The pH Report.