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Richard Koo


May 17, 2011


Richard Koo is chief economist at

QE2 has transformed commodity markets into liquidity-driven Nomura Research Institute. This is his
markets personal view.

As I spoke with investors in London and Geneva last week, markets were rocked by a
resurgence of fiscal problems in Greece and a steep drop in the price of silver and Richard Koo
other commodities.

In London there was talk in the market that the drop in commodity prices had left a
handful of investors facing serious losses. If true, it suggests that the preceding rise in
commodity prices was driven by speculation and not by real demand.
Another frequent topic of discussion was QE2, indicating that many investors
established large positions based on the availability of substantial amounts of liquidity
under this program.
All these factors suggest that a number of markets have been transformed into
liquidity-driven markets, and that asset prices in those markets may have risen to levels
that cannot be justified by the real economy.

Two problems with QE2

In the debate surrounding these issues, I was struck by (1) the misconceptions of QE2
held by some market participants and (2) the fundamental problems inherent in QE2. In
this report I would like to touch on both of these questions.
Turning first to the market’s misconceptions regarding QE2, many investors believe
that the large-scale quantitative easing programs implemented by the Federal Reserve
and the Bank of England have left the markets awash in money, and that this money is
providing substantial support for the real economy and markets.
The Fed’s balance sheet is now three times its pre-crisis size, and the Bank of England
has taken similar measures. This balance sheet expansion has been the focus of much
attention in the markets.
When a central bank triples the size of its balance sheet, the amount of liquidity being
supplied to the market is also tripled. Under ordinary conditions, that would result in a
tripling of the money supply, the key indicator of the money available for use by the
private sector.
A tripling of the money available for consumption and investment by the private sector
puts strong upward pressure on GDP and prices, including asset prices. That is why
investors had such high expectations of quantitative easing.

How money supply grows under ordinary conditions

In reality, however, the money supply has betrayed market expectations inasmuch as it
has increased only modestly in response to quantitative easing, if at all. To understand
the significance of this, we need to understand the relationship between the money
supply and central bank-supplied liquidity.

See Appendix A-1 for important

disclosures. Analysts employed
by non US affiliates are not
registered or qualified as
research analysts with FINRA in
the US.
Nomura | JPN Richard Koo May 17, 2011

When a central bank provides liquidity to the market, it buys government debt or other securities in exchange for cash. The
previous owners of those securities, typically financial institutions, take that money and attempt to turn a profit by loaning it out.
If borrowers use the money to buy goods and services, the providers of those goods and services will take the money they
receive and deposit it at their banks, leading to an increase in private-sector deposits.
Banks receiving those new deposits will increase their lending accordingly. If the new borrowers also use the borrowed money
to buy goods and services, the providers will again take the proceeds and deposit them in a bank account, driving further growth
in private-sector deposits.
Both private-sector deposits and lending continue to increase as this process is repeated. However, banks cannot lend out the
entire amount of new deposits because a portion must be set aside as statutory reserves. This creates a leakage in the cycle of
increasing deposits and lending equal to the increase in statutory reserves.
Consequently, the process of deposit growth will continue until the entire amount of liquidity supplied by the central bank is set
aside as reserves. If the statutory reserve ratio is 10%, the deposit growth process will end once the liquidity injected by the
central bank has been transformed into deposits worth 10 times the initial amount.
The money supply data, composed mostly of bank deposits*, are closely watched by market participants because of their close
relationship to GDP and price levels. The numerical relationship between the money supply and the initial liquidity injected by
the central bank is called the money multiplier. In the previous example, the multiplier would be 10.
*Strictly speaking, the money supply includes bank deposits, currency, and coins.

Money supply has shown little change despite sharp increase in liquidity
What actually happened, however, is quite different. Market liquidity in the US and the UK almost tripled. But the money supply,
which represents funds actually available for use by the private sector, has increased little if at all since the financial crisis in
Figure 1 shows the US monetary base (ie liquidity) along with the money supply and commercial bank loans and leases
outstanding (ie private-sector credit), rebased so that August 2008 = 100. The graph confirms that these three indicators moved
in unison, as the textbooks predict, until the Lehman-inspired financial crisis. Since then, however, liquidity has surged to nearly
300, yet the money supply stands at 115.
As explained above, growth in the money supply should entail a corresponding increase in bank lending under ordinary
conditions. Yet lending had fallen to 90 by April 2011.
In other words, the money supply—which supports consumption and investment—has exhibited little growth during this period.
We cannot expect an expansion of the economy or an acceleration of inflation without an increase in the money supply. There is
no reason why inflation—apart from imported inflation—should increase at a time when the money supply is not growing.
The inflation currently being reported around the world is of the imported variety, typically involving oil and food. “Home-grown”
inflation, like the core deflator for personal consumption expenditures shown in the bottom portion of Exhibit 1, remains
Nomura | JPN Richard Koo May 17, 2011

Fig. 1: Relationship between monetary indicators breaks down during balance sheet recession (1): US
(08/8 = 100, seasonally adjusted)
280 Monetary base
260 Money supply (M2)
240 Loans and leases in bank credit
140 Down
% y-y)
2.5 Consumer spending deflator (core)

08/1 08/4 08/7 08/10 09/1 09/4 09/7 09/10 10/1 10/4 10/7 10/10 11/1 11/4 (yy/m)

Note: Commercial bank loans and leases, adjustments for discontinuities made by Nomura Research Institute.
Sources: Board of Governors of the Federal Reserve System, US Department of Commerce

Quantitative easing has had no effect in UK, either

An almost identical set of conditions can be observed in the UK. As Exhibit 2 shows, the UK money supply increased from 100
in August 2008 to just 103 in March 2011 despite a near tripling of the liquidity supplied by the Bank of England. Bank lending
fell sharply over the same period, from 100 to 86.
When the Bank of England announced a bold program of quantitative easing in the spring of 2009, bank officials proclaimed that
they would revive the British economy by drastically expanding the money supply and avoiding the policy missteps of Japan.
Yet two years later, the BOE’s policies have had no such impact.
The pound has also fallen to historic lows on a real effective exchange rate basis, which is leading to higher prices via imported
inflation. Home-grown inflation, meanwhile, remains muted, as in the US.
Nomura | JPN Richard Koo May 17, 2011

Fig. 2: Relationship between monetary indicators breaks down during balance sheet recession (2): UK
(08/8 = 100, seasonally adjusted)
265 Reserve balances + notes & coin
Money supply (M4)
220 Banking lending (M4)
175 08/8
130 Down
115 16%
% y-y)
6 CPI (ex indirect taxes)
07/1 07/4 07/7 07/10 08/1 08/4 08/7 08/10 09/1 09/4 09/7 09/10 10/1 10/4 10/7 10/10 11/1 (yy/m)
Note: (1) Reserve balances data are seasonally unadjusted. (2) Money supply and bank lending data exclude intermediate financial institutions.
Sources: Bank of England, Office for National Statistics, UK

Reasons for divergence of liquidity supply and money supply

The decline in private-sector credit in the US and the UK is attributable to both the unwillingness of banks to lend and the
unwillingness of the private sector to borrow. The two factors are rooted in balance sheet problems and are indications that both
countries remain in balance sheet recessions.
When a bubble collapses, the value of assets drops, leaving only the corresponding liabilities on the balance sheets of
businesses and households. To fix their “underwater” balance sheets, companies and individuals do whatever they can to pay
down debt and avoid borrowing new money even though interest rates have fallen to zero. Banks, for their part, are not
interested in lending to overly indebted companies or individuals, and often have their own balance sheet problems. With no
borrowers or lenders, the deposit-growth process described above stops functioning altogether.
US banks now appear slightly more willing to lend money, although that is not the case in the UK. In neither country, however,
are there any signs of greater willingness to borrow among businesses and households.

Investors still under misconception that greater liquidity automatically leads to money
supply growth
Despite this reality, many investors in both the US and the UK appear to labor under the misconception that an increase in the
liquidity supply due to quantitative easing will inevitably boost the money supply.
Something that many investors have yet to realize is that although central banks in both countries have substantially increased
their supply of liquidity, the money available for the private sector to invest or consume—the money supply—has shown
negligible growth.
In fact, the contraction in private-sector credit in both the US and the UK suggests that the money multiplier may have turned
negative at the margins. If so, the two countries should be more concerned about deflation than inflation.
When launching QE2, Fed Chairman Ben Bernanke demonstrated an understanding of the conditions described above by
stating that—like QE1—it would not increase the money supply (for details, see the 16 November 2010 issue of this report). But
Nomura | JPN Richard Koo May 17, 2011

many market participants appear to have overlooked this point. I think this represents a major misconception regarding QE2 by
private investors.

Government borrowing has supported money supply growth

The question, then, is how to explain the modest growth in the money supply at a time when private-sector credit has steadily
contracted. A look at Japan’s experience shows that the answer lies in increased bank lending to the government.
As long as the government continues to borrow, banks can continue lending (by buying government bonds) even if the private
sector is deleveraging in an attempt to clean up its balance sheet.
If the government spends the proceeds of those debt issues, the people on the receiving end of that spending will deposit
money with a bank somewhere, leading to an increase in the money supply.
In effect, the money supplies of both the US and the UK are being supported by government borrowing. If the two governments
chose to embark on fiscal consolidation, their money supplies would contract.

Portfolio rebalancing effect was primary objective of QE2

So what are the actual problems inherent in QE2? Mr. Bernanke has stated from the beginning that QE2 would not lead to an
increase in the US money supply.
If so, why did the Fed carry out QE2? The simple answer is that it believed QE2 would result in a portfolio rebalancing effect.
The portfolio rebalancing effect can be described as follows. When the Fed buys a specific asset (in this case, longer-term
Treasury securities), the price of that asset rises. That prompts private investors to re-direct their funds to other assets, which
leads to a corresponding increase in the price of those assets.
Private-sector sentiment may improve as asset prices rise, and if that prompts businesses and households to spend more
money, the economy may improve. In effect, the Fed hopes that quantitative easing will lift the economy via the wealth effect.
Inasmuch as the balance sheet recession was triggered by a drop in asset prices, monetary policy that serves to support asset
prices may also help pull the economy out of the balance sheet recession.

Unable to buy more government bonds or private-sector debt, investors have few places
to turn
In the hope of producing a portfolio rebalancing effect, Chairman Bernanke declared that the Fed would purchase $600bn in
longer-term Treasury securities between November 2010 and June 2011. This was roughly equivalent to all expected Treasury
debt issuance during this period.
From a macroeconomic standpoint, these purchases of government debt meant that—in aggregate—private-sector financial
institutions would be unable to increase their purchases of US Treasury securities, because all of the growth in Treasury
issuance would be absorbed by the Fed.
The fact that US businesses and households were rushing to repair balance sheets by deleveraging meant that—again, viewed
in aggregate—private investors would be unable to increase their purchases of private-sector debt.
With the private sector no longer borrowing and all new issues of government debt being absorbed by the Fed, US institutions
found themselves with few investment options.

So funds found their way to equities and commodities

The only remaining destinations for these funds were equities, commodities, and real estate. Real estate had just been through
a bubble and remained characterized by heavy uncertainty. In commercial real estate, for example, banks—at the request of US
authorities—are engaging in a policy of “pretend and extend” and offering loans to borrowers whose debt they would never roll
over under ordinary circumstances. That means that current prices do not accurately reflect true market prices. Housing prices,
meanwhile, resumed falling late in 2010.
UK house prices have been falling since mid-2010, and the Halifax House Price Index dropped 1.4% in April 2011 alone (the
decline was 3.7% on a y-y basis).
The only remaining options for private-sector investors have been stocks and commodities. That, in my opinion, is why both
markets have surged since the announcement of QE2.
Nomura | JPN Richard Koo May 17, 2011

Relationship between asset bubbles and discounted cash flow values

While this may demonstrate the portfolio rebalancing effect of QE2, the real problems are yet to come. Asset prices, after all,
are supposed to be determined by the future cash flows generated by the asset. More specifically, the fair value of an asset—ie
its discounted cash flow (DCF) value—is defined as the sum of the asset’s future cash flows discounted by an appropriate
interest rate.
A bubble is defined as a situation in which asset prices rise to levels far in excess of their DCF values.
In the immediate aftermath of a burst bubble, investors tend to pay extremely close attention to DCF analysis. That is hardly
surprising, since they lost money because they ignored DCF values and chased prices higher.
The fact that real estate prices in the US and the UK have continued to fall in spite of quantitative easing by the Fed and the
BOE is an indication that market participants do not believe that quantitative easing can raise the DCF value of real estate in
those markets.

Question is whether prices lifted by QE2 can be justified by DCF analysis

The question is whether prices that have risen in response to the Fed’s QE2 can be justified by the yardstick of DCF, and
whether commodity prices that rose following QE2 can be justified in terms of real demand.
There is nothing to worry about if market participants have concluded that equity prices are in a range that can be justified by
DCF analysis. But for that to be the case, corresponding growth in the economy and corporate profits are required.
In other words, current share prices can be justified using the yardstick of DCF analysis if both GDP and corporate profits are
expected to increase at a robust pace going forward. The same is true of commodity prices.

Prices that cannot be justified by DCF analysis are in a bubble

The problem surfaces if people decide that today’s share prices cannot be (conservatively) justified using DCF analysis because
of factors such as persistent high unemployment, falling housing prices, and sluggish money supply growth.
That would suggest that share prices and commodity prices are in a QE2-driven bubble and that now may be an opportunity to
sell assets that have been lifted higher by QE2.
Given that policy rates are already at zero, leaving no room for further rate cuts, and that fiscal policy in the US and the UK is
headed in the direction of austerity, which would impact negatively on the economy, there is little prospect of policy support for
an increase in DCF values, either.

End to new bubbles would further exacerbate balance sheet recession

Viewed objectively, the central banks are trying to push up asset prices using quantitative easing and the portfolio rebalancing
effect. The resultant rise in asset prices based on this effect represented a potential bubble—or at least a liquidity-driven
event—from the start.
The question is whether the real economy can keep pace with asset prices formed in those liquidity-driven markets. If it cannot,
higher asset prices will be considered a bubble and will collapse at some point. The resulting situation could be much more
severe than if quantitative easing had never been implemented to begin with.
In other words, if stock and commodity prices are in fact in a bubble and if those bubbles were to collapse, the balance sheets of
the financial institutions and hedge funds making investments with the expectation of higher asset prices could suffer heavy
damage, exacerbating the balance sheet recession in the broader economy.

QE2 was Bernanke’s big gamble

When the situation is viewed in this light, we come to the realization that Mr. Bernanke’s QE2 was in fact a major gamble. It was
a gamble in the sense that the Fed tried to raise share prices with QE2. If the wealth effect resulting from those higher prices led
to improvements in the economy, the higher asset prices would ultimately be supported by higher real demand, thereby
demonstrating that prices were not in a bubble.
However, I cannot help but feel that the portfolio rebalancing argument was putting the cart before the horse, in the sense that it
is ordinarily a stronger real economy that leads to higher asset prices, and not the other way around.
It might be possible to sustain the portfolio rebalancing effect for some time if conditions were such that investors were totally
oblivious to DCF values. But with market participants paying close attention to DCF values, any delay in the economic recovery
will naturally bring about a correction in market prices, thereby causing the portfolio rebalancing effect to disappear.
Nomura | JPN Richard Koo May 17, 2011

DCF analysis is still dependent on human judgment, and there is no guarantee that all analysts will come to the same
conclusion. For instance, former Fed Chairman Alan Greenspan repeatedly argued that housing prices had not diverged
significantly from DCF values at a time when the US was in the midst of its biggest housing bubble ever.
The Economist magazine in the UK, meanwhile, argued that US housing prices had diverged substantially from DCF prices and
called a bubble. In the end, it was the Economist whose calculations were correct.

We must not put excessive faith in recovery supported by fiscal stimulus

Recent growth in the US economy also presents a danger in that it is making people complacent. Relatively strong economic
indicators—data showing the economy created more than 200,000 jobs in the latest month for which data are available—have
encouraged talk of fiscal consolidation. But the economy is far from achieving a self-sustaining recovery.
As indicated in the discussion of the money supply above, private-sector credit is not only not expanding but continues to shrink.
That the money supply and GDP are still posting modest growth is only because the government continues to borrow and spend.
This is identical to the phenomenon observed in the US in 1933–36 and in Japan after the collapse of the Heisei bubble.
In other words, the US economy is being supported solely by massive fiscal stimulus amounting to 9% of GDP. It is not growing
because of the efforts of the private sector.

Japanese government in 1997 overlooked economy’s reliance on government spending

The reason why government officials and economists decided that Japan was ready for fiscal consolidation in 1997 was that in
1996, the year before the policy was implemented, Japan posted GDP growth of 4.4%, the highest of any G7 nation.
In reality, however, most of that 4.4% growth was made possible by government support in the form of fiscal stimulus worth 5%
of GDP. Once that support was removed in 1997, the Japanese economy fell off a cliff and experienced five consecutive
quarters of negative growth.
The US and UK economies and money supplies are currently being supported by fiscal stimulus totaling 9–10% of GDP, far
larger than the Japanese stimulus in 1997. The deflationary impact could be severe if these supports were removed.
At the very least, the continued decline in private-sector credit is evidence that the two economies are not being supported by
growth in private-sector credit.

Roosevelt made same mistake in 1937

This pattern of expansion in the money supply and the economy despite an absence of private-sector credit growth was also
observed in 1933–36 as the US economy emerged from the Great Depression. President Franklin D. Roosevelt was unaware of
the importance of this relationship and, believing that the economy was already on a self-sustaining growth path, embarked on a
path of fiscal consolidation in 1937.
The US economy consequently fell into a severe recession characterized by sharply lower production and drastically higher
unemployment. It took the Japanese attack on Pearl Harbor for the US economy to recover from the resulting damage.

Central bank and government policy at odds in US and UK

Whereas the Fed and the Bank of England hope that the portfolio rebalancing effect of quantitative easing will boost the
economy and lift the DCF value of assets, governments in the two nations have come out in favor of fiscal consolidation, which
would depress both the economy and the DCF value of assets.
Fed Chairman Ben Bernanke continues to argue that now is not the time for fiscal consolidation. BOE Governor Mervyn King,
meanwhile, is arguing that more fiscal austerity is needed.
I think it is important that we keep a close eye on the level of asset prices that can be justified on a DCF basis (1) in the current
moderate-growth economy and (2) in the event that fiscal consolidation puts the brakes on economic growth.

Richard Koo’s next article is scheduled for release on 31 May 2011.

Nomura | JPN Richard Koo May 17, 2011

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