A few years ago as a result of the global financial crisis, central banks used quantitative easing to purchase securities from the market in order to lower interest rates and increase the money supply. The money was then distributed to lenders as a way of stabilising their balance sheets and then promoting lending.
The point is that despite everything feeling normal, we are actually in uncharted territory as far as economics is concerned. Following a major economic event that threatened to devastate the international economy and usher in a new great depression, central banks responded by dramatically increasing the money supply. This in turn resulted in a period of artificially low interest rates, more capital circulating in the economy, and the resumption of economic growth. It also led to (frankly), the return to old bad habits of investing in assets that have been shown so recently to be bubble-prone.
This, despite the fact that the downsides of quantitative easing have not been figured out. We are very inexperienced with quantitative easing: this is, after all, a new maneouvre. There are two main drawbacks to quantitative easing that people regularly draw attention to, namely, that QE may cause inflation, and that it may devalue domestic currencies. But I believe that there is another, unscoped, potential risk to QE that will rear its ugly head in years to come.
The loan hierarchy
To understand this third risk, we need to look at the loan hierarchy. The lenders to whom central banks have distributed the proceeds of QE have a hierarchy in terms of how they look at investment propositions. To radically simplify everything, let’s look at a hospital and the people who work within it and the way that banks may proceed in terms of funding certain investment propositions.
A doctor comes to a bank to get a loan to buy a house. The bank looks at the doctor’s income, assets, and credit score, and notes that the doctor has a stable professional job and a good chance of repaying the loan over time. The lender therefore approves the loan.
A nurse comes to a bank to get a loan to buy a house. The bank looks at the nurse’s income, assets, and credit score, and notes that the nurse has a stable professional job, albeit at a lower level of salary, and a good chance of repaying the loan over time. The lender therefore approves the loan.
A part-time hospital orderly comes to a bank to get a loan to buy a house. The bank looks at the orderly’s income, assets, and credit score, and notes that while the orderly only works part time for the hospital, and that there is less of a margin on being able to service the loan due to an increase in asset valuations as a result of all the doctors and nurses having recently purchased houses, that the income nevertheless appears stable, and since the bank has relaxed their lending criteria due to having a surplus of capital to lend, there are some doubts, but if they don’t approve the loan, the orderly will go to the bank down the street and get it approved there.
On and on it goes, during times of surplus capital and relaxed lending restrictions, until every man, woman and dog in the hospital has a loan. Eventually, the lenders are providing interest free loans to people to buy chainsaws to cut butter. Which leads to…
The mass creation of bad debt
A consequence of having so much capital circulating the economy is that irresponsible lending practices will likely result (again, as they did ten years ago). Lenders will reach further and further down the hierarchy in order to find ‘deals’. Even under normal circumstances, this could cause problems, but in the long run it also causes a major unforeseen event, which is that…
Loan defaults will be more responsive to interest rate rises
In the old days, when central banks increased interest rates in order to reduce inflation, they did so with at least some level of awareness of what sort of impact the interest rate might have on reductions in consumer spending.
With QE, however, this has all changed. With dramatically more money in the economy, and that capital circulating around and around again due to the credit multiplier, the responsiveness of any nation to an increase in the central bank’s interest rate movements will be unpredictable and potentially more severe.
To illustrate this, shifting interest rates upwards by 25 basis points would have dramatically more impact on consumer spending if it applied to one hundred million loans rather than 25 million loans. Particularly if the bottom 75 million loans are at the bottom of the loan hierarchy: loan defaults will skyrocket.
My concern is not just that lenders may not have realised this, my concern is that people on the street (who under times of lax lending restrictions themselves become professional capital mispricers) may not have realised this. This is one of those things that is going to be so simple in hindsight – and yet, few, if anyone, will have seen it coming.