Mauldin April 3

Central Banks, Credit Expansion, and the Importance of
Being Impatient
JOHN MAULDIN | April 3, 2015
We live in a time of unprecedented financial repression. As I have continued writing about this, I have
become increasingly angry about the fact that central banks almost everywhere have decided to address
the economic woes of the world by driving down the returns on the savings of those who can least afford
it retirees and pensioners.
This weeks Outside the Box, from my good friend Chris Whalen of Kroll Bond Rating Agency, goes farther
and outlines how a low-interest-rate and massive QE environment is also destructive of other parts of the
economy. Counterintuitively, the policies pursued by central banks are actually driving the deflationary
environment rather than fighting it.
This is a short but very powerful Outside the Box. And to further Chriss point I want to share with you a
graph that he sent me, from a later essay he wrote. It shows that the cost of funds for US banks has dropped
over $100 billion since the financial crisis, but their net interest income is almost exactly the same. What
changed? Banks are now paying you and me and businesses $100 billion less. The Feds interest-rate policy
has meant a great deal less income for US savers.
Outside the Box is a free weekly economic e-letter by best-selling author and renowned financial expert,
John Mauldin. You can learn more and get your free subscription by visiting www.mauldineconomics.com
It is of the highest irony that Keynesians wanted to launch a QE policy that would increase the value
of financial assets (like stocks), which they claimed would produce a wealth effect. I made fun of this
policy some five years ago by calling it trickle-down monetary policy. Subsequent research has verified
that there is no wealth effect from QE. Well, it did make our stocks go up, on the backs of savers. Weve
transferred interest income from savers into the stock market. Weve made retirement far riskier for our
older pensioners than it should be.
As Chris writes:
Indeed, in the present interest rate environment, to paraphrase John Dizard of the Financial
Times, it has become mathematically impossible for fiduciaries [brokers, investment advisors
and managers of pension funds and annuities] to meet the beneficiaries future investment return
target needs through the prudent buying of securities.
Everywhere I go I talk with investment advisors and brokers who are scratching their heads trying to
figure out how to create retirement portfolios that provide sufficient income without significantly moving
out the risk curve at precisely the wrong time in their clients lives. It is a conundrum that has been made
for more difficult by Federal Reserve policy.
Economics Professor Larry Kotlikoff (Boston University) and our mutual friend syndicated financial
columnist Scott Burns came by to visit me last week. I have talked with Larry on and off over the last few
years, and Scott and I go back literally decades. A few years ago, Scott and Larry wrote a very good book
called The Clash of Generations. Now, Larry has branched off on his own and written a really powerful
manual on Social Security called Get Whats Yours: The Secrets to Maxing Out Your Social Security.
I will admit I have not paid much attention to Social Security. I just assumed I should start mine when Im
70, as so many columns I have read suggested. Larry and I recently spent an hour discussing the Social
Security system (or perhaps it would be better to call it the Social Security Maze). Three thousand pages
of law and tens of thousands of regulations and so many nuances and gotchas that it is really difficult
to understand what might be best in your particular circumstances. Larry asked me questions for about
two minutes and then proceeded to make me $40,000 over the next five years. It turns out I qualify for an
obscure (at least to me) regulation that allows me to get some Social Security income for four years prior
to turning 70 without affecting my post-70 benefits. There are scores of such obscure rules.
Larry says it is more often the case than not that he can sit down with somebody and make them more
money than they thought they were going to get. As one reviewer says:
This book is necessary for three reasons: Social Security is not intuitive, and sometimes makes no
sense at all. Two, Americans act against their best interests, leaving all kinds of money on the table.
Three, there is usually a however with Social Security rules. Worse, Social Security is now up to
three million requests every week, but Congress keeps cutting back budget, staff, hours and whole
offices. Combine that with the complexity factor, and the authors conclude you cannot trust what
Social Security advises. Great.
If you or your parents are on Social Security or you are approaching that age, you really should get this
book. Did you know that if you are divorced you can get a check for half of your former spouses Social
Security income without affecting their income at all? But you cant know whether this is a good strategy
unless you look at other options.
How many retirees or those nearing retirement know about such Social Security options as file and
suspend (apply for benefits and then dont take them)? Or start stop start (start benefits, stop them, then
restart them)? Or just as important when and how to use these techniques? Get Whats Yours covers
the most frequent benefit scenarios faced by married retired couples, by divorced retirees, by widows and
widowers, among others. It explains what to do if youre a retired parent of dependent children, disabled,
or an eligible beneficiary who continues to work, and how to plan wisely before retirement. It addresses the
tax consequences of your choices, as well as the financial implications for other investments.
The book is written in Larrys usual easy-to-read style, and you can jump to the sections that might be
most relevant to you. The book is $11 on Kindle and under $15 at Amazon. This might be some of the
better financial advice that you get from reading my letter: go get a copy of Get Whats Yours.
I cant guarantee it will make you $40,000 in five minutes, but it can show you how to navigate the system.
Larry also has a website with some inexpensive software to help you maximize your own Social Security.
Seeing as how Social Security is the largest source of income for most US retirees, this is something
everyone should pay attention to.
It is time to hit the send button. Quickly, we finalized the agenda for the 2015 Strategic Investment
Conference. You can see it by clicking on the link. Then go ahead and register before the price goes up.
This really is the best economic conference that I know of anywhere this year.
Your wondering how long theyll pay me Social Security analyst,
John Mauldin, Editor

Outside the Box
Central Banks, Credit Expansion, and the Importance of Being Impatient

This research note is based on the presentation given by Christopher Whalen, Kroll Bond Rating Agency
(KBRA) Senior Managing Director and Head of Research, at the Banque de France on Monday, March 23,
2015, for an event organized by the Global Interdependence Center (GIC) entitled New Policies for the Post
Crisis Era. KBRA is pleased to be a sponsor of the GIC.
Summary
Investors are keenly focused on the Federal Open Market Committee (FOMC) to see whether the U.S.
central bank is prepared to raise interest rates later this year or next. The attention of the markets has
been focused on a single word, patience, which has been a key indicator of whether the Fed is going
to shift policy after nearly 15 years of maintaining extraordinarily low interest rates. This week, the
Fed dropped the word patience from its written policy guidance, but KBRA does not believe that the
rhetorical change will be meaningful to fixed income investors. We do not expect that the Fed will attempt
to raise interest rates for the balance of 2015.
This long anticipated shift in policy guidance by the Fed comes even as interest rates in the EU are negative
and the European Central Bank has begun to buy securities in open market operations mimicking those
conducted by the FOMC over the past several years. Investors and markets need to appreciate that,
regardless of what the FOMC decides this month or next, the global economy continues to suffer from the
effects of the financial excesses of the 2000s.
The decision by the ECB to finally begin U.S. style quantitative easing (QE) almost eight years after the
start of the subprime financial crisis in 2007 speaks directly to the failure of policy to address both the
causes and the terrible effects of the financial crisis. Consider several points:

QE by the ECB must be seen in the context of a decade long period of abnormally low interest
rates. U.S. interest rate policy has been essentially unchanged since 2001, when interest rates were
cut following the 9/11 attack. The addition of QE 1-3 was an effort at further monetary stimulus
beyond zero interest rate policy (ZIRP) meant to boost asset prices and thereby change investor
tolerance for risk.
QE makes sense only from a Keynesian/socialist perspective, however, and ignores the long-term
cost of low interest rate policies to individual investors and financial institutions. Indeed, in the
present interest rate environment, to paraphrase John Dizard of the Financial Times, it has become
mathematically impossible for fiduciaries to meet the beneficiaries future investment return target
needs through the prudent buying of securities. (See John Dizard, Embrace the contradictions of
QE and sell all the good stuff, Financial Times, March 14, 2015.)
The downside of QE in the U.S. and EU is that it does not address the core problems of hidden offbalance sheet debt that caused the massive run on liquidity in 2008. That is, banks and markets
in the U.S. globally face tens of trillions of dollars in off-balance sheet debt that has not been
resolved. The bad debt which is visible on the books of U.S. and EU banks is also a burden in the
sense that bank managers know that it must eventually be resolved. Whether we talk of loans by
German banks to Greece or home equity loans in the U.S. for homes that are underwater on the
first mortgage, bad debt is a drag on economic growth.
Despite the fact that many of these debts are uncollectible, governments in the U.S. and EU refuse
to restructure because doing so implies capital losses for banks and further expenses for cashstrapped governments. In effect, the Fed and ECB have decided to address the issue of debt by
slowly confiscating value from investors via negative rates, this because the fiscal authorities in the
respective industrial nations cannot or will not address the problem directly.
ZIRP and QE as practiced by the Fed and ECB are not boosting, but instead depressing, private
sector economic activity. By using bank reserves to acquire government and agency securities, the
FOMC has actually been retarding private economic growth, even while pushing up the prices of
financial assets around the world.
ZIRP has reduced the cost of funds for the $15 trillion asset U.S. banking system from roughly half
a trillion dollars annually to less than $50 billion in 2014. This decrease in the interest expense for
banks comes directly out of the pockets of savers and financial institutions. While the Fed pays
banks 25bp for their reserve deposits, the remaining spread earned on the Feds massive securities
portfolio is transferred to the U.S. Treasury a policy that does nothing to support credit creation
or growth. The income taken from bond investors due to ZIRP and QE is far larger.
No matter how low interest rates go and how much debt central banks buy, the fact of financial
repression where savers are penalized to advantage debtors has an overall deflationary impact
on the global economy. Without a commensurate increase in national income, the elevated asset
prices resulting from ZIRP and QE cannot be validated and sustained. Thus with the end of QE in
the U.S. and the possibility of higher interest rates, global investors face the decline of valuations
for both debt and equity securities.
In opposition to the intended goal of low interest rate and QE policies, we also have a regressive
framework of regulations and higher bank capital requirements via Basel III and other policies
that are actually limiting the leverage of the global financial system. The fact that banks cannot or
will not lend to many parts of society because of harsh new financial regulations only exacerbates
the impact of financial repression. Thus we take income from savers to advantage debtors, while
limiting credit to society as a whole. Only large private corporations and government sponsored
enterprises with access to equally large banks and global capital markets are able to function and
grow in this environment.
So what is to be done? KBRA believes that the FOMC and policy makers in the U.S. and EU need to
refocus their efforts on first addressing the issue of excessive debt and secondly rebalancing fiscal policies
so as to boost private sector economic activity. Low or even negative interest rate policies which punish
savers in order to pretend that bad debts are actually good are only making things worse and accelerate
global deflation. Around the globe, nations from China to Brazil and Greece are all feeling the adverse
effects of excessive debt and the related decline in commodity prices and overall economic activity. This
decline, in turn, is being felt via lower prices for both commodities and traded goods that is, deflation.
In the U.S., sectors such as housing and energy, the effects of weak consumer activity and oversupply
are combining into a perfect storm of deflation. For example, The Atlanta Fed forecast for real GDP has
been falling steadily as the underlying Blue Chip economic forecasts have also declined. The drop in
capital expenditures related to oil and gas have resulted in a sharp decline in related economic activity
and employment. Falling prices for oil and other key industrial commodities, weak private sector credit
creation, falling transaction volumes in the U.S. housing sector, and other macroeconomic indicators all
suggest that economic growth remains quite fragile.
To deal with this dangerous situation, the FOMC should move to gradually increase interest rates to
restore cash flow to the financial system, following the famous dictum of Adam Smith that the Great
Wheel of circulation is the means by which the flow of goods and services moves through the economy:
The great wheel of circulation is altogether different from the goods which are circulated by means of it.
The revenue of the society consists altogether in those goods, and not in the wheel which circulates them
(Smith 1811: 202).
Increased regulation and a decrease in the effective leverage in many sectors of banking and commerce
have contributed to a slowing of credit creation and economic activity overall. And most importantly, the
issue of unresolved debt, on and off balance sheet, remains a dead weight retarding economic growth. For
this reason, KBRA believes that investors ought to become impatient with policy makers and encourage
new approaches to boosting economic growth.
Related Publications:
U.S. Real Estate Prices Show Signs of Rising Again (Published February 23, 2015)

GSE Litigation Affirms that Fannie Mae and Freddie Mac are Sovereign Credits (Published
February 19, 2015)
Swiss Francs & Global Debt Deflation (Published January 21, 2015)
Analytical Contact: Christopher Whalen, Senior Managing Director cwhalen@kbra.com, (646) 731-2366
Copyright 2015 John Mauldin. All Rights Reserved.
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Central Banks, Credit Expansion, and the Importance of

John Mauldin, Editor

Central Banks, Credit Expansion, and the Importance of Being Impatient

Copyright 2015 John Mauldin. All Rights Reserved.

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