Central banks have attempted to encourage risk-taking by pumping liquidity into financial markets. Mr Bernanke publicly credited his QE program for pumping up the small-cap Russell 2000 index. The BoE has been even more forthcoming about the intentions of its QE program:
Andrew Haldane, the BOE’s chief economist, told a conference in London that reviving investors’ appetite for risk was one of the forgotten goals of crisis-fighting measures such as cutting interest rates to rock-bottom and buying safe assets such as government bonds, a policy known as quantitative easing.
“That’s why we did it. Lower rates and QE were an exercise in, among other things, trying to stimulate risk taking,” Mr. Haldane said at the Camp Alphaville conference in London. The economic cost of inaction would have been considerable, he argued. He said without ultralow rates and QE, the U.K. economy would be around 6% smaller than it is now.
Mr. Haldane was responding to widespread concerns that low rates and plentiful central bank cash are fueling excessive risk-taking that could be sowing the seeds of a future financial crisis.
Many people, for example John Hussman, have derided QE as being ineffective in driving economic growth. Certainly the transmission mechanism espoused by the Fed, the so-called “wealth effect” is at best weak and probably non-existent. But there are real transmission mechanisms that are driven indirectly by the financial bubbles that QE creates.
The most obvious are margin debt and stock buybacks financed with borrowed funds. Like the mortgage credit of the previous bubble, these add credit to the economy while inflating the bubble. That new credit adds purchasing power to the economy which shows up in economic growth.
QE does indeed encourage risky behavior, if only by removing risk-free assets from the markets while adding liquidity. In the US, this has shown up in auto loans, which are now being issued for an average of over 120% of the value of the auto being purchased – obviously, prior deficit balances being rolled over. Worse, credit quality has deteriorated as subprime borrowers have been embraced for this form of credit – it worked so well the last time, I guess.
Speaking of credit quality, it would be remiss of me not to mention student loans which have been the largest source of new consumer credit. Government continues to encourage this form of predatory lending, and indeed is itself the largest predator, if not the greediest.
The real issue is that, when the bubble pops, these forms of financing all go into reverse and drive economic decline by withdrawing credit as the bubble deflates. The reversal of these mechanisms will provide a key part of the impetus for the now inevitable deflationary depression.