In Japan, the 90’s and the 00’s are known as lost decades as the Japanese economy experienced economic stagnation after a large financial crisis. Interest rates have remained below 1% since 1994 and the Bank of Japan invented quantitative easing (QE) in the late 1990’s. Recently there’s been some talk about expecting further cuts or a continuing of QE from the ECB. Given the Japanese track record I believe this would be a poor choice. I’ve covered QE and monetary policy more than a few times, and you can read previous posts here. This week though, I want to focus on financial markets and how, according to the Austrian school of economics, QE and similar policies can make financial markets ineffective.
Let’s start by giving a simplified explanation of price signals, what they are and why they are especially relevant to financial markets in QE times. One of the main ideas of prominent Austrian School economists like Ludwig von Mises and Friedrich Hayek is that prices signal perceived value, and therefore the best way to allocate resources efficiently is for the market to set a price without interfering, letting supply and demand create the correct price which then can lead to correct resource allocation. This should apply to all goods and services, land, labour, and capital but is most relevant in markets where prices are prone to quickly change according to what is going on. To make this clearer let me use and example, if you go to your local supermarket they won’t change their price for flour just because wheat futures are down since last week even though that could be considered relevant supply and demand information. In financial markets though, and especially in highly liquid markets like government bonds or blue-chip stocks prices do change quickly to account for new information which allows capital to be allocated to the firms which the market deems to be the best use of capital.
QE can disrupt proper pricing in both direct and indirect ways. For example, if the central bank buys government bonds for the sake of injecting more money into the system and to try to stimulate the economy then the price of government debt is largely irrelevant as the yield on the debt isn’t the reason for the purchase. The logical thing to do as a holder of government debt knowing this is to charge a higher price as the central bank will almost certainly pay it, which drives down yields. This creates a situation where government debt isn’t priced correctly as there is a large-scale actor in the market which isn’t acting rationally from an investment standpoint which complicates the correct allocation of resources for both the individual security which the central bank buys and the larger system as other fairly priced securities appear either cheap or expensive compared to the mispriced security. Another less direct way that QE can disrupt correct pricing in financial markets is by artificially lowering interest rates, i.e. the cost of money. If interest rates are very low and expected to stay very low then it incentivises borrowing, which could lead not only to overleveraging but more importantly to severe misallocations of resources as a result of artificially under-priced money.
It could be that my line of thinking is flawed, given that I think more QE from the ECB is very likely let’s hope so, and I’d appreciate your thoughts on the subject! You can reach me on Twitter and if you want to read more blog posts about economics you can find that here. Please come back next week for a new blog post and I’d be grateful if you shared this blog post with a friend or co-worker who might find it interesting.
Written by Karl Johansson, Founder of Ipoleco
Cover Photo by Pixabay on Pexels
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