The Policy liquidity monopoly

Rick Rieder, Russ Brownback and Navin Saigal contend that if developed market policy authorities play their cards right, the Covid Crisis can actually become an opportunity for the marriage of monetary and fiscal policy to be targeted toward creating the right liquidity equilibrium that supports virtuous private sector investment and a re-rating of growth prospects.

Last September, we wrote a blog post entitled The Monetary Policy Endgame that laid out a possible future path for monetary policy, should economic growth falter, productivity not materialize, and populist politics continue to thrive. Last month, in Revisiting The Monetary Policy Endgame, we suggested that if central banks want to win the war against a negative potential endgame, they should work with fiscal authorities to enable private investment. In this post, we examine how the marriage of monetary and fiscal policy should ideally be targeted toward creating the right liquidity equilibrium to support virtuous private sector investment.

Changing the rules of the game: why liquidity matters

The Covid Crisis has forced an evolution in policy. For the first time since World War II, U.S. policymakers have married monetary and fiscal policy, whereby the Federal Reserve and the U.S. Treasury work together to inject cash from the Fed’s quantitative easing (QE) programs directly into the private sector, to combat the economic fallout from the pandemic. But as economies eventually normalize in a post-Covid world, we must imagine what a sustainable liquidity equilibrium under this new policy regime might look like – where policy liquidity is judiciously provisioned to the real economy in ways that facilitate investment in high-return targets. In order to envision a successful liquidity policy, we must first understand liquidity’s massive influence on an economy – and to do so we need look no further than the iconic American board game: Monopoly.

First published by Parker Brothers in 1935, Monopoly is named after the economic concept of monopoly —the domination of a market by a single entity (player). Today, the game of Monopoly not only can be played traditionally, but also virtually, on a smartphone or tablet, against in-game computer opponents. In the digital-age version of Monopoly, the rules can also be customized in ways that dramatically alter the game's tempo and its outcome. When the game’s rules are set at extremes, whereby the “liquidity” available to players is tight in one extreme and plentiful in another, the winning strategies and the game’s outcomes are vastly different.

In the game with “tight liquidity,” each player begins with $1,000, instead of the $1,500 that forms a standard game. There is no salary earned by passing “Go” (the standard earned is $200), and there is no money awarded to players that land on “Free Parking.” In this game of reduced liquidity, the winning strategy is to have a deflationary mindset - to hoard cash, bypassing every opportunity to purchase properties as they are landed on. In contrast, the computer opponents are programed to pay full price for all the properties they land on. With almost no opportunity to replenish cash from Go or Free Parking, they quickly face liquidity crises. Computer opponents are forced to pass on opportunities to buy unowned properties for simple lack of cash, so they get auctioned off. A human player that remains flush with cash can then purchase these properties for pennies on the dollar and build a portfolio of rent-producing assets with huge cap rates. Very quickly the cash-strapped computer players go bankrupt, failing to anticipate the deflationary spiral endgame that an excessively tight liquidity regime would inevitably lead to.

In the game with “plentiful liquidity,” each player begins with $2,000, a salary of $400 is awarded on passing Go ($800 if the Go space is actually landed on), and the incentive for landing on Free Parking is $500, plus the proceeds of any fees or taxes collected from all players in between each Free Parking award. In the plentiful liquidity variation of the game, the winning human strategy is to deploy an aggressive inflationary approach by not only purchasing every property landed on, but also obtaining the computer opponents’ properties by offering to pay up for them in secondary market “trades.” The computer opponents are programed to take the quick profit and fail to see that a game with virtuous ongoing increases in liquidity will unleash animal spirits and facilitate real-economy velocity. Incremental development of houses and hotels will result (real world equivalents include corporate capital expenditures, capex, and research and development, R&D), with attractive returns rewarding the entrepreneur who embraces proactive investment in these productive assets. By amassing and developing the most property the soonest, the human player likely vanquishes their computer opponents.

Concerning liquidity, life Imitates play

Just as the policies dictating liquidity can profoundly influence the outcome in Monopoly games, policy liquidity has been setting the rules of the global macro landscape for the past decade, a de facto monopoly in terms of its dominance on macroeconomic regimes, in a manner that transcends traditional real economy influences. Prior to the Covid-19 crisis, nominal output in much of the world was already trending toward lower levels than at any point in modern history, which is at least partly the result of an aging demographic in much of the developed world. Accordingly, what was considered a neutral monetary policy stance had become ever easier in absolute terms, including both lower policy rates and a large and growing pool of central bank liquidity.

Underscoring the importance of global liquidity growth are the two occasions since the Global Financial Crisis (GFC) in which liquidity failed to grow: in 2015, and again in 2018-19 as the Fed endeavored to reduce its balance sheet. In both the fourth quarter of 2015 and 2018, liquidity vigilantes ultimately unleashed havoc on financial markets amid global growth scares, suggesting that an ample and growing pool of liquidity has become part of the neutral policy prescription supporting markets and the real economy today. Both occasions required policy pivots toward renewed liquidity growth.

The reality is that despite its monopoly power over the rules of the modern economy, central banks’ liquidity policy often remains an afterthought relative to interest-rate policy. But an overreliance on interest rates to stimulate an economy, especially at or through the zero bound, can have extremely damaging long-term side-effects. While interest rates that are too high can push an economy into stall speed by destroying consumption (auto loans and mortgages become unaffordable, for instance), interest rates that are too low can have the same stall-speed impact by damaging the very sources of those loans – namely, the banking system.

It is said that a chain is only as strong as its weakest link – likewise a capitalist economy is only as strong as its financing system, and in this regard the developed world has taken divergent paths over the last decade. Both U.S. and European banks formed their GFC bottom in March 2009, but since then the S&P 500 Financials Index has more than quadrupled in market value, while the Euro Stoxx Banks Index has fallen another 25%; a truly remarkable feat when one recalls the palpable panic in the system back in 2009 (see graph). How can a banking system that is ascribed less value by the market today than was the case at the height of the GFC be expected to provide the financing needed to restore an economy’s output back to equilibrium, much less amid another crisis? And how will the individuals and corporations with potentially attractive investments in R&D projects and capital expansions (the houses and hotel equivalents in our Monopoly example) have the confidence to make leveraged investments when the systemic banking system is so precariously positioned?

US & EU bank performance since 3/6/09 GFC bottom

This situation presents us with a vicious cycle, as both the suppliers of capital and demand for capital end up crippled when the banking system is the weakest link in the economic chain. By contrast, the relative health of the American banking sector is what has allowed it to weather the Covid Crisis without fears of insolvency rising appreciably.

Policy offers some reasons for optimism

Yet, there are two reasons to hope that the Covid Crisis has sparked a positive rethinking in policymakers’ balancing act between interest rate and liquidity policy. First, the marriage of fiscal and monetary stimulus demonstrates a credible source of demand for capital. Just like our Monopoly example, the global macro environment needs a player with deep enough pockets to make real investments that prevent asset prices (both real and financial, debt and equity) from falling into a deflationary spiral. There is no player with deeper pockets than a government, funded by its central bank, in its own currency, and both U.S. and European governments have shown a commitment to taking on this role. If aggregate demand can be shored up directly by the government, it follows that interest rate policy no longer has to be the economy’s only hope of restoring equilibrium, and the pressure on the banking system can be alleviated by setting rates at sustainable levels.

Second, global liquidity is growing robustly today. In response to the Covid Crisis, the Fed has purchased assets that are the equivalent of more than 10% of the U.S. Aggregate Bond index, over only a three-month span, and in so doing has monetized the vast majority of the U.S. Congress’ Main Street fiscal stimulus. At the same time, the European Central Bank (ECB) and the Bank of Japan (BOJ) have also responded to the pandemic with liquidity injections that have been married to impressive fiscal stimulus. A robust liquidity policy shores up the demand for capital by giving all players the confidence to invest, just like the knowledge of capital injections at “Go” and “Free Parking” pull forward the purchases of property, houses and hotels in Monopoly. However, here is where our Monopoly analogy (thankfully!) falls short, because rather than rigid, programmed computer players, the private participants in the global economy respond instantly and dynamically to the right fiscal and monetary cues by ramping up their own spending, so that the government can eventually take a back seat again, once the path to durable growth and inflation is restored.

While long-term risks to growth remain

While the global crisis response has credibly bridged the economic gap caused by unprecedented lockdowns, if secular headwinds were already leading to growth and inflation deficiencies pre-Covid, it is likely that policy will need to remain supportive even after Covid, to ultimately achieve policymakers’ growth, inflation and employment targets. In the years ahead, there is a real risk that throughout the developed world, declining population growth, an aging demographic, and persistent excess capacity will continue to drive suboptimal economic outcomes. Given policy liquidity’s dominant role in influencing said outcomes, central banks would be well advised to ensure an ample supply of liquidity, while staying well within the bounds of either onerous inflation or financial imbalances that risk creating systemic instability.

Given today’s inflation deficit problem, and no obvious systemic financial imbalances to constrain incremental policy accommodation, some ongoing debt monetization could have tremendous efficacy as a means of catalyzing a virtuous investment cycle – provided the proceeds are used wisely. Indeed, monetization proceeds could be directed at building out a 5G network, funding green initiatives, rebuilding productivity-enhancing infrastructure, or encouraging population growth through immigration policy and fertility incentives. The corollary to this would be a rewriting of investment-stifling regulation to incentivize high-return investments long after the initial waves of stimulus have done their job. High-return investments would then help to create the outsized growth needed to ultimately outrun the increase in indebtedness that was required to finance them.

With bold and visionary leadership from both central banks and fiscal authorities, the Covid Crisis could become a unique opportunity to rewrite the global economic rulebook, beginning with ample systemic liquidity provision, so that the pernicious secular headwinds dogging DM economies can be finally conquered.