QE Breeds Instability

[marmar]

via Naked Capitalism:



Ilargi: QE Breeds Instability
Posted on June 6, 2015 by Yves Smith


Yves here. While Ilargi discusses how a follower of Minsky would predict that QE would end badly, Keynes, a successful speculator, gave more detailed explanation of why low interest rates were a trap in his General Theory. As Nathan Tankus wrote in a 2013 post:

Since Bernanke started talking about “tapering off” Quantitative Easing, the bond markets have freaked out. This is a very logical reaction.

Before last month, it seemed like QE would go on indefinitely. Once that belief was shaken – even in the slightest fashion – everyone ran to the exits. Bernanke and other Federal Reserve economists appear bewildered by this phenomenon. The impression one gets from their follow-up comments is that they wished they could ask bond speculators “did you read the damn speech?” The answer, of course, is no and for good reason.

All investors need to know is the conditions under which QE (and for that matter, the Zero Interest Rate Policy) will be pursued has changed. Now the substantive change may actually be relatively minor, but that’s irrelevant to speculators. The reason is very simple: those holding assets with longer maturities will take huge capital losses with relatively small changes in interest rates (As a reminder: it is basic “bond math” that a change in interest rates send bond prices in the reverse direction. A rise in interest rates makes bond prices fall and a fall in interest rates make bond prices rise). It is better to exit now when those future changes are uncertain then take even more massive losses.

This is the logic behind the actual “liquidity trap” presented by Keynes in his general theory. Specifically, Chapter 15 entitled “The Psychological and Business Incentives To Liquidity.” Here he argues that every fall in the interest rate relative to what is commonly believed to be a “safe” rate increases the “risk of illiquidity”. The the “risk of illiquidity” is the risk of holding an asset not easily convertible into money at “book” value (this also means an asset is more or less “liquid” based on the relative easiness to convert into money “book” value). Further, rather then seeing interest as a return to “waiting”, Keynes argues that it is “a sort of insurance premium to offset the risk of loss on capital account”.

How can one evaluate the uncertainties relative to the “insurance”? By what has been subsequently known as “Keynes’s square rule”. .......................(more)

http://www.nakedcapitalism.com/2015/06/ilargi-qe-breeds-instability.html