Since Lehman Brothers' collapse, it's been an upside-down world

With the crisis over, the unconventional measures in place are hurting consumers

Feb 23, 2014 @ 12:01 am

By John Mauldin and Jonathan Tepper

When Lehman Brothers Holdings Inc. went bankrupt and American International Group Inc. was taken over by the U.S. government in the fall of 2008, the world almost came to an end. Over the next few weeks, stock markets went into free fall as trillions of dollars of wealth was wiped out. However, even more disturbing were the real-world effects on trade and businesses. A strange silence descended on the hubs of global commerce.

As international trade froze, ships stood empty near ports around the world because banks would no longer issue letters of credit. Factories shut and millions of workers were laid off as commercial paper and money market funds used to pay wages froze. Major banks in the United States and the United Kingdom were literally hours away from shutting down and ATMs were on the verge of running out of cash. Banks stopped issuing letters of credit to former trusted partners worldwide. The interbank market simply froze, as no one knew who was bankrupt and who wasn't. Banks could look at their own balance sheets and see how bad things were and knew that their counterparties were also loaded up with too much bad debt.

The world was threatened with a big deflationary collapse. A crisis that big only comes around twice a century. Families and governments were swamped with too much debt and not enough money to pay it off. But central banks and governments saved the day by printing money, providing almost unlimited amounts of liquidity to the financial system. Like a doctor putting a large jolt of electricity on a dying man's chest, the extreme measures brought the patient back to life.


The money-printing that central bankers did after the failure of Lehman Brothers was entirely appropriate in order to avoid a Great Depression II. The Federal Reserve and other central banks were merely creating some money and credit that only partially offset the contraction in bank lending. The initial crisis is long gone, but the unconventional measures have stayed with us. Once the crisis was over, it was clear that the world was saddled with high debt and low growth. In order to fight the monsters of deflation and depression, central bankers have gone wild. Central bankers kept on creating money. Quantitative easing was a shocking development when it was first trotted out, but these days the markets just shrug. Now, the markets are worried about losing their regular injections of monetary drugs. What will withdrawal be like?

The amount of money central banks have created is simply staggering. Under quantitative easing, central banks have been buying every government bond in sight and have expanded their balance sheets by more than $9 trillion. Yes, that's $9,000,000,000,000—12 zeros to be exact. (By the time you read this, the number will probably be a few trillion higher, but who's counting?) Numbers so large are difficult for ordinary humans to understand. As Sen. Everett M. Dirksen supposedly said, “A billion here, a billion there, and soon you're talking about real money.”

To put it in everyday terms, if you had a limit of $9 trillion on your credit card, you could buy a MacBook Air for every single person in the world. You could fly everyone in the world on a round-trip ticket from New York to London. We could go on, but you get the point: it's a big number. In the years since the Lehman Brothers bankruptcy, central bankers have torn up the rulebook and are trying things they have never tried before. Usually, interest rates move up or down depending on growth and inflation. Higher growth and inflation normally means higher rates, and lower growth means lower rates. Those were the good old days when things were normal. But now central bankers in the United States, Japan and Europe have pinned interest rates close to zero and promised to leave them there for years. Rates can't go lower, so some central bankers have decided to get creative. Normally, central banks pay interest on the cash banks deposit with them overnight. Not anymore. Some national banks, such as those of Switzerland and Denmark, have even created negative deposit rates. We now live in an upside-down world.

Money is effectively taxed (by central bankers, not representative governments) to get people to spend instead of save. These unconventional policies are generally good for big banks, governments, and borrowers (who doesn't like to borrow money for free?), but they are very bad for savers. Near-zero interest rates and heavily subsidized government lending programs help the banks to make money the old-fashioned way: borrow cheaply and lend at higher rates. They also help insolvent governments, allowing them to borrow at very low costs. The flip side is that near-zero rates punish savers, providing almost no income to pensioners and the elderly. Everyone who thought their life's savings might carry them through their retirement has to come up with a Plan B when rates are near zero.

In the bizarre world we now inhabit, central banks and governments try to induce consumers to spend to help the economy, while they take money away from savers who would like to be able to profitably invest. Rather than inducing them to consume more, they are forcing them to spend less in order to make their savings last through their final years!

Savers and investors in the developed world are the guinea pigs in an unprecedented monetary experiment. There are clear winners and losers as prudent savers are called upon to bail out reckless borrowers.

In the United States, United Kingdom, Japan and most of Europe, savers receive close to zero percent interest on their savings, while they watch rents and the price of gasoline and groceries go up. Standards of living are falling for many, and economic growth is elusive. Today is a time of financial repression, where central banks keep interest rates below inflation. This means that the interest savers receive on their deposits cannot keep up with the rising cost of living. Big banks are bailed out and continue paying large bonuses, while older savers are punished. Growing our way out of our problems would be ideal, but it isn't an option.


Today's battle with deflation requires a constant vigilance and use of Code Red procedures. Unfortunately, just as in the film “A Few Good Men,” Code Reds are not standard operating procedures or conventional policies. Central bankers are manning their battle stations using ugly weapons to get the job done. They are punishing savers, encouraging people to borrow more, providing lots of liquidity and weakening their currencies.

This unprecedented global monetary experiment has only just begun, and every central bank is trying to get in on the act. It is a monetary arms race, and no one wants to be left behind. The Bank of England has devalued the pound to improve exports by allowing creeping inflation and keeping interest rates at zero. The Federal Reserve has tried to weaken the dollar in order to boost manufacturing and exports. The Bank of Japan, not to be outdone, is now trying to radically depreciate the yen. By weakening their currencies, these central banks hope to boost their countries' exports and get a leg up on their competitors. In the race to debase currencies, no one wins.

But lots of people lose.

Emerging-market countries such as Brazil, Russia, Malaysia and Indonesia will not sit idly by while the central banks of the developed world weaken their currencies. They, too, are fighting to keep their currencies from appreciating. They are imposing taxes on investments and savings in their currencies. All countries are inherently protectionist if pushed too far. The battles have only begun in what promises to be an enormous, ugly currency war. If the currency wars of the 1930s and 1970s are any guide, we will see knife fights ahead. Governments will fight dirty — they will impose tariffs and restrictions and capital controls.

The arsonists are now running the fire brigade. Central bankers contributed to the economic crisis the world now faces. They kept interest rates too low for too long. They fixated on controlling inflation, even as they stood by and watched investment banks party in an orgy of credit. Central bankers were completely incompetent and failed to see the great financial crisis coming. They couldn't spot housing bubbles, and even when the crisis had started and banks were failing, they insisted that the banks they supervised were well regulated and healthy. They failed at their job and should have been fired. Yet governments now need central banks to erode the mountain of debt by printing money and creating inflation. Investors should ask themselves: “If central bankers couldn't manage conventional monetary policy well in the good times, what makes us think that they will be able to manage unconventional monetary policies in the bad times?”

And if they don't do a perfect job of winding down condition Code Red, what will be the consequences? Economists know that there are no free lunches. Creating tons of new money and credit out of thin air is not without cost. Massively increasing the size of a central bank's balance sheet is risky and stores up extremely difficult problems for the future. Central-bank policies may succeed in creating growth, or they may fail. It is too soon to call the outcome, but it is clear that the experiment is unlikely to end well.

The endgame for the current crisis is not difficult to foresee; in fact, it's already under way. Central banks think they can swell the size of their balance sheet, print money to finance government deficits, and keep rates at zero with no consequences. Central bankers think they have the foresight to reverse their unconventional policies at the right time. They've been wrong in the past, and they will get the timing wrong in the future. They will keep interest rates too low for too long and cause inflation and bubbles in real estate, stock markets and bonds. What they are doing will destroy savers who rely on interest payments and fixed coupons from their bonds. They will also harm lenders who have lent money and will be repaid in devalued dollars, if they are repaid at all.


We are already seeing the unintended consequences of this Great Monetary Experiment. Many emerging-market stock markets have skyrocketed, only to fall back to Earth at the mere hint of any end to Code Red policies.

Junk bonds and risky commercial-mortgage-backed securities are offering investors the lowest rates they have ever seen. Investors are reaching for riskier and riskier investments to get some small return. In normal times, retirees could buy bonds and live on the coupons. Not anymore. Government-bond yields are now trading below the level of inflation, guaranteeing that any investor who holds the bonds until maturity will lose money in real terms.

The coming upheaval will affect everyone. No one will be spared the consequences: from savers who are planning for retirement to professional traders looking for opportunities to profit in financial markets. Inflation will eat away at savings, government bonds will be destroyed as a supposedly safe asset class, and assets that benefit from inflation and money-printing will do well.

Excerpted with permission from “Code Red: How to Protect Your Savings from the Coming Crisis,” by John Mauldin and Jonathan Tepper (Wiley, 2014). Mr. Mauldin is chairman of Mauldin Economics. Mr. Tepper is a fund manager, macroeconomic analyst, writer and entrepreneur.


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