Why do people invest in the stock market?
What is the consequence of all this money printing? Can ASX investors benefit from it; or is it a financial cliff we’re all headed towards. In this article we delve deeper in the economic theory and come up with some conclusions to help subscribers come to grips with the big picture driving stocks of all sizes.
How governments are paying for ballooning deficits
In last week’s Blue Chip Value we looked at how Quantitative Easing is enabling governments around the world to raise money in order to pay for ballooning deficits, occurring due to a reduction in taxation receipts and because of massive stimulus packages, such as JobSeeker and JobKeeper in Australia.
What is Quantitative Easing?
Just to remind, QE is a monetary policy tool governments use to increase money supply. One arm of the government, the central bank (in Australia’s case the RBA, or the US Federal Reserve) is buying from another arm of government, the Treasury. The government is printing money (through the central bank) which it then uses to buy Government Treasury bonds to fund its operations.
QE is used because interest rates are so low that the conventional monetary policy of promoting investment and economic activity through reducing interest rates was proven ineffective during the financial crisis.
While interest rates might be nominally low at the moment, the benchmark 10-year US Treasury rate is 0.69%, the real interest rates, which allow for inflation are still too high.
If you get investment going then you get economic activity going
QE is used to facilitate borrowing by businesses and households at low rates of interest. What government officials are doing is turning the monetary spigots on to say: just borrow money and invest. The theory is that if you get investment going then you get economic activity going.
Balancing inflation and why it’s important
They’ve been using QE in earnest in the US since 2012; but in some ways it’s failed because in that time they’ve kept undershooting the inflation target of 2%. Why is inflation important? Because debt obligations are fixed and inflation signifies wages growth. Having some inflation is good because it means you can pay your debts. Having too much is bad because those debts can get out of hand.
As we mentioned in Blue Chip Issue 58, one of the reasons banks use unconventional monetary policy is the Quantitative Theory of Money: where MV = PY (the supply of money x the velocity of money = the price level x the real level of income). If you are not a subscriber, click here to access 14-days free.
COVID-19 has meant money is not changing hands
As we discussed the key to why there hasn’t been inflation, despite unparalleled printing of money is V, which is the rate at which money changes hands. Like the financial crisis, COVID-19 is not going to get V going any time soon.
What about modern monetary theory (MMT)?
MMT has been around for at least 15 years but part of the issue is that it can mean so many different things to different people. The essence at the extreme it is the government getting whatever money it needs from the central bank rather than selling bonds to private sector and taxes.
The title is misleading, because the key assertion is that fiscal policy (government spending) takes the lead in fine tuning macro-economic policy. In the past fiscal policy has been used as a redistribution mechanism (taking from the rich and giving to everybody); while monetary policy has focused on inflation. Now it’s conflating the two!
MMT predicts fiscal stimulus is associated with high inflation, but this has patently not been the case. The theory is attractive because it posits that there is no restraint to deficits and provides another way to generate the Keynesian multiplier effect. The thing is: there is no data that supports this.
What investors need to pay attention to is the Quantitative Theory of Money.
This has been governing the activities of the US Federal Reserve since Ben Bernanke’s tenure as governor (2006-2014) and remains the guiding principle for the current governor Jerome Powell.
QTM has been around since the Spanish currency was inflated by an influx of gold and silver during the late 15th and early 16th century (an increase in M (gold) caused an increase in P (price of money). This assumed that V (velocity of money) was static. But since then the theory has been developed, such as by David Hume in the mid-18th century and interest rates become a focus for driving economic activity, being the price of money. Then the Swedish economist Knut Wicksell in the late 19th century came up with the idea of the neutral rate of interest: the rate at which economic activity is stable, inflation is stable and the economy (GDP) is growing at trend.
Does Australia’s low inflation mean that the prevailing interest rate is too high?
The prevailing rate in the economy refers to the government’s official overnight rate. Right now in Australia it is at 0.25%, having come down from 0.75% in February. Australia has been experiencing low inflation (sub 2%) for a number of years and more recently declining economic activity due to COVID-19. Wicksell would posit that the prevailing interest rate is too high.
What’s going on? There is a growing view that that the precautionary mode for savings has increased markedly since the financial crisis in 2010-2012. Investors are buying safe havens or risk free assets such as US Treasuries and the problem is that there are not enough of them. This means that the velocity of money is falling.
Inflation will one day return when the neutral rate of interest starts to increase. The US official rate is zero; the neutral rate must be lower. But that day may not be in our lifetime.
The point for investors to take out is that high inflation remains a low probability risk, in the single digits as a percentage. Investing in stocks remains the best option.
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