Wednesday, May 29, 2013

Central Banking Explained!

Isaac Newton, the father of modern physics, was an odd duck. Despite his almost relentless devotion to the practice of the scientific discipline, Sir Isaac spent a good deal of his leisure time dabbling in the field of alchemy — the pseudo-science that is focused on discovering a way to transform base metals such as lead into gold.
Never mind that actually discovering a way to do this would undermine the very basis of the value proposition for gold, he and many other intellectuals of his time were hellbent on solving the problem (ostensibly so that, at least for a time, it would feel good for a while).
Were Sir Isaac to be alive today, he’d be delighted to learn that the ability to manufacture value out of nothing finally has arrived. All you need to have is the reins of a Central Bank in your hands, and a printing press at your disposal.
Today, the future of the world’s nations and economies no longer respond to the whims of presidents, premiers and chancellors. It responds to the whims of the central bankers who head up the world’s most influential Central Banking Units: the Federal Reserve, the Bank of England, the European Central Bank, the Bundesbank, the Bank of China and the Bank of Japan, among a handful of others.
Twenty years ago, almost none of us could recite the names of central bankers outside the heads of the central banks in our own regions. Today, names such as Ben Bernanke, Mervyn King, Jean-Claude Trichet and, more recently, Mario Draghi are familiar if not well known to most of us, wherever we happen to reside around the globe.
It has been said that no one is remembered for a catastrophe avoided. But they should be. Over the past several years, people like Bernanke and King and Trichet have been vilified by the press when they probably should be celebrated as heroes.
To understand in greater depth exactly why, you have to read Neil Irwin’s latest tome, The Alchemists. Before reading it, I thought I understood the causes of the financial crisis. After all, it’s been written about endlessly in books including The Big Short, Too Big to Fail, A Colossal Failure of Common Sense, Mr. Market Miscalculates, Panic! and many, many others. But Irwin’s perspective is from the vantage point of the central bankers who had to develop the right policy responses to the myriad events that continued to unfold, day after to day, and, to a large extent, continue to unfold today.
The ultimate objective throughout has been and continues to be to preserve the stability of the financial markets while containing price inflation. Throughout the past six to seven years, doing so has forced the central bankers to take unprecedented risks in hopes of averting a total collapse of the bond markets, without stimulating a rash of global hyperinflation. The policy tools at their disposal have included interest rates, of course, which we all know they've managed to keep at historical lows for a surprisingly prolonged period of time. The other policy tool they have used prolifically, particularly recently, is to print money through the mechanism of bond purchases. When they do this, they’re effectively spending money they didn’t have before to purchase assets they didn’t own, the same way a bank creates money when it lends on deposits at ratios greater than the deposits. What is this practice, other than alchemy?
As the central banks buy bonds, former bondholders now have cash they can use to invest in other sectors of the financial markets — in the stock market, in the corporate bond markets, and in the private equity and debt markets, including real estate. This money simply didn't exist before, and by forcing it into these sectors of the markets, the bankers are hoping to stimulate growth in the financial sector. (By inflating the value of these assets, they hope, business confidence will improve, and as business confidence improves, investment spending and job creation will pick up.)
The other thing that happens when central bankers buy bonds is that money that would have purchased these securities, be they residential or commercial mortgage–backed securities or government bonds, is crowded out of those markets and forced to move into other areas of the financial and private markets. In buying back bonds, then, the central bankers not only are flooding the markets with capital (creating a so-called Wall of Money), but they’re concentrating that capital in the markets they think will do the most good for the economy.
Equally important, by buying up bonds, they’re holding the lid on rates by supporting the market for these bonds. This is particularly important when you’re talking about markets that are starting to implode, as the market for RMBS was during the height of the financial crisis and, more recently, as the markets for the debt of southern European sovereign nations were (and have been) for the past several years.
When bond markets threaten to implode, issuers can’t refinance. When issuers can’t refinance, they default. When they default, there are serial, domino-like effects. Bond values collapse and eventually go to zero. When bond values collapse and eventually go to zero, the banks that hold those securities as collateral go bust. When banks even threaten to go bust, depositors stage a run on the bank. This is precisely what happened to Northern Rock in the United Kingdom, which essentially was the poster child that ultimately triggered the mess we’re in, when depositors started their run on Northern Rock in the wake of the Lehman crash.