FM: Recently you wrote that markets are starting to reflect concern that central banks will be forced to tighten policy earlier. What have you seen?
MS: The major thing to remember is that we have been in a major transition in the global economic, financial and political landscapes and the road from the old landscape to the new one, which [is uncertain], is quite dangerous. We are definitely not at the end of the road. As a result, that environment has created a [market space] with no shock absorbing and a lot of fragility and vulnerability to adverse developments; we have had many of those. The [fragile environment] is being amplified by huge deleveraging on the private sector part, and as a result it has made us vulnerable to a lot of situations. What we have seen in the financial sector in 2008 and what we have seen in Europe [are] all part of the same problem--we basically have reduced the level of liquidity that was available in the economy, growth came down and as a result some of the underlying structural imbalances showed up. Because that process of deleveraging is a long-term [thing] and it is still a work in progress, it has forced us to be in that kind of adjustment process much longer that we are used to.
We have been facing a sick patient that keeps on getting higher and higher dosages of morphine without going through the serious operation…. At some point, central banks were forced to go to extreme measures that weren’t on their menu of policy tools before, like [quantitative easing] (QE). When they saw that they brought interest rates to zero and that did very little, they thought that they would get the global economy going by pushing long-term rates very low, [but] that has led to very little help so far. The reason is that we are still in the midst of deleveraginig; we are still in the process where fear and uncertainty are what are controlling market behavior. A lot of it has been our own [doing]. The regulation, some of it justified, made the banks less likely to lend and as a result we saw little benefit of that very aggressive monetary policy in the real economy.
At one point we will realize that the use of only monetary policy the way we did it failed to do the job and we may need to [switch] to more fiscal policies. When you do that, it will be the end of [the] limitless monetary liquidity injections that we have seen so far. Some of the unease is showing itself in the words of central banks themselves. You are starting to hear more dissenting voices within the central banks where they are uncomfortable with the fact that certain banks have been pouring so much liquidity into global domestic economies and have very little success to show for it.
FM: Jim Sinclair told us QE is not a policy choice but the only option on the table given our debt obligation and the size of outstanding derivatives floating around. Do you agree?
MS: It is too simplistic. The reason being is that QE wasn’t on the table a few years ago. It is something that we invented, so to speak, in this economic crisis. When QE didn’t do the job as much as we hoped, we developed a new concept called twist, which again failed to [improve] the real economy. It is not the only option. The right option should have been to have a more proactive policy targeted at supporting growth. For instance, while monetary policy so far primarily was providing liquidity, especially to the financial sector, which was right at the time to prevent a huge financial meltdown, we could have had a monetary policy with a two-tier system where we provide the banks funds for their own use with high interest rates and [low rates] if they are willing to take some risk and lend to the real economy. So QE is just one tool. You could have been more targeted toward growth.
If banks want to keep [liquidity] and give themselves more cushion, they would have to pay a higher price. QE was a desperate move because they already moved rates as low as they could and saw that it was not doing the job, so they said, ‘let’s affect the real economy through the long end but how do you affect the real economy from the long end?’ It is by the fact that rates people pay for mortgages are lower and the rates that companies pay for their loans are lower. What happened however, is the real estate market had much bigger problems. [The] exact rates of mortgages and loans from banks to businesses weren’t so much an issue of rates, it was an issue of whether to extend credit--so QE didn’t do the job. It may have given some financial institutions the benefit of playing the carry trade because you had zero rates; it gave banks the [ability] to replenish their balance sheets but when the [longer] rates remained flat there was less and less benefits to those policies.