QE is causing Capacity-driven Deflation

The first of two commentaries exploring quantitative easing and the impact of deflation

1. London prime two-bed flats

In late 2014 Bridgie and I were thinking of buying a London flat. We came to find a functional flat in a good part of town. I was considering whether to bid on the functional flat when to my surprise the agent called and offered it at 92% of the original offer (which was already below the earlier advertised price). I decided the next step was to do some further research! It turns out that the market in two and three bed flats in London is starting to soften. The reason is that 54,000 flats of this scale are currently either planned or already under construction in London with capital from investors, mostly from Asia, who are looking for a safe home for their savings. This compares with annual turnover of around 4,000 of such flats.

Rents on high-end London flats rose to high levels over the past few years (apparently £ 35,000 per year is not uncommon, representing a 3.5% cash return on a £1 m flat). However although the international jet set can afford that rent for their London pied-à-terre it is not clear the average young professional couple, with after-tax income of perhaps £ 60,000 net between them can afford this. It seems likely that rents for these flats will fall for a period – once the new supply comes to the market.

Bridgie and I have not yet bought. From time to time we get calls from agents asking if we might now like to buy.

2. This commentary argues that “QE” will lead to deflation in the medium term

This Commentary argues that Quantitative Easing, which many of us thought would lead to inflation, is instead leading to deflation as a result of over-investment in capacity (e.g. over-building of London high end flats).

This insight is not intuitive. It seems more natural to think that government money printing will lead to inflation. A further difficulty for my theory is “QE” did sharply lift prices of leverageable assets (such as London flats) in the early years after its implementation. It is therefore important to qualify my argument. In this Commentary I am going to argue that QE is deflationary in the medium term.

3. Why will quantitative easing lead to deflation? 

QE as a policy is designed, at least implicitly, to lift the prices of investment assets. In the short term the increased investment that results from these rises should be good for employment and GDP growth. It may even be inflationary in the short term.

In the medium term however, the very activity that QE encourages: “investment” subsequently increases capacity in the sectors that have been stimulated. This in turn increases supply of goods or services (in our example prime London residential rental space).

As increased supply meets demand prices will fall i.e. deflation occurs – unless of course something changes (some even more aggressive QE?!) to increase demand relative to supply. These price falls will be experienced first in goods and service prices (and rentals) in the affected sector. Subsequently capital values of the over-built sectors of the economy will themselves fall (as is just now starting to happen to prime London residential property).

4. Where, oh where is an investor to hide? (amidst a deflation) 

The remainder of this Commentary reviews the history of Quantitative Easing. In my next Commentary I will explore which investment sectors are going to be most impacted by QE. And which may be safer i.e. less prone to over-investment. To do this I will develop a measure I call “Capacity Elasticity” – being the sensitivity of the capacity of a sector to rises in its expected profitability. I will argue that sectors that have low Capacity Elasticity should be safer places to hide in the years to come than the (mostly leveraged) sectors that rocketed up in the early years of QE.

5. Keynes general theory  

Keynes’ 1943 General Theory of Employment, Interest and Money is a surprisingly up to date book. I know this because although I had managed to avoid it at university (I was a card-carrying Thatcherite at the time) I finally read it in 2009*. And what a treasure trove of misguided (albeit beautifully expressed) ideas it is.

One of the central monetary arguments of the General Theory (Keynes returns to this idea again and again) is that a government which wishes to stimulate economic activity should not merely trade in short end government bills in order to inject or withdraw cash from the economy (an age-old practise of governments in control of their money supplies) but instead should buy investment assets, including government bonds but also riskier assets such as mortgages and corporate debt  right along the maturity spectrum.

See e.g. Ch. 15 Section III:

If the monetary authority were prepared to deal both ways on specified terms in debts of all maturities, and even more so if it were prepared to deal in debts of varying degrees of risk, the relationship between the complex of rates of interest and the quantity of money would be direct ….. Perhaps a complex offer by the central bank to buy and sell at stated prices gilt-edged bonds of all maturities, in place of the single bank rate for short term bills, is the most important practical improvement which can be made in the technique of monetary management.+

Keynes goes on to argue, and, boy, does he turn out to have been correct, that such buying will lift the prices of investments and thereby investment activity. He expected the lift in activity to come in part because of a “wealth effect”** (when people feel richer); in part because of an income effect (as interest rates fell – freeing up household and corporate cash flows for other purposes – a major factor in QE stimulation of the western economies in recent years); and thirdly because, if investment assets and buildings’ values are increased from (say) approximately their “replacement cost” to 1.3 X replacement cost, then investors and developers will construct new companies and buildings in order to profit from the difference (it is on this third effect I focus in this Commentary). The investment effect should apply across all sectors that are exposed to financial leverage (or to investors who discount projects using financial calculations). Thus the effect should apply to iron ore or coal mines, to companies which manufacture motor cars, or software, or nursing homes. Indeed to companies who make almost anything.

Keynes was clear that the monetary investments he advocated should in turn stimulate investment in the wider economy. He believed “that the scale of investment is promoted by a low rate of interest … thus it is to our best advantage to reduce the rate of interest to that point …. at which there is full employment” (Chapter 24, Section II). In other words, once asset prices rise, entrepreneurs and investors will get busy creating or growing businesses. They will build the things the capital markets are bidding in order to profit from selling these businesses (e.g. on the stock exchange or to pension funds looking for real estate investments) for more than they cost to build.

In an extreme QE world capitalism becomes (cue our large investment banking and private equity industries) a supplier of a “product” called investment capacity. With the client for that investment capacity being increasingly (either directly or indirectly) the government***.

6. The early years of quantitative easing

Keynes’ activist theories for government intervention in investment and interest rate markets were adopted in piecemeal fashion at various times in the 20th century. A few of many examples of government support of asset markets include:

  • the New Deal expenditures which helped relieve the US Great Depression
  • support by the US and other governments of residential and farm mortgage financing
  • European credit formation via government support of industrial lending banks
  • government support of leading industrial companies in Japan and Korea
  • “Think  Big” projects in New Zealand in the 1970s
  • US formation of Resolution Trust Corporation (RTC) in the early 1990s
  • lowering of US interest rates to near zero in the period after the dot com crash of 2000 – a rate well below the rate of inflation and therefore well beyond traditional monetary policy,
  • US government support of the investment banks and insurers in late 2008
  • Chinese financial repression and associated channelling of savings into real estate and other investment projects at local and national government level especially post 2009
  • ECB support of the European banks after the sovereign debt crisis of 2011.

These programmes were not described as Quantitative Easing at the time, and were not normally seen as monetary support of asset markets. Instead they were seen as social, industrial, monetary or “lender of last resort” measures. Also, unlike Quantitative Easing which uses printed money to make the purchases, quite often the projects were financed by on-sale of the assets (as happened with RTC), via securitisation of the assets (as happens with Fannie Mae) or via sterilising bond issuance. However despite not being the “full blown” QE we are experiencing today it remains the case these projects were programmes of systematic government support of asset markets. As such they were the “early years” of Quantitative Easing.

7. The coming of age of quantitative easing – a devil that now has a name

Government interventions into asset markets became systematic in 2010 when the Bank of England announced a programme to purchase government bonds as well as corporate bonds and mortgage securities. Further programmes to purchase treasury bonds and mortgage securities were announced by the Federal Reserve (in 2011), the BOJ (in 2013) and ECB (in 2015). None of these governments promised on-sale or sterilisation of these purchases via the issuance of bills or bonds**** i.e. these programmes have so far all been financed with printed money i.e. with expansion of the core money supply of these countries (see graph).

Total Assets of Major Central Banks


Sources: Haver Analytics, Yardeni Research

Quantitative easing thus grew, after 2010, from being an un-named series of crisis responses into a formal programme of government action.

8. Quantitative easing will fail because it interrupts the capacity cycles of the economy

I believe the flaw in Keynes’ theory of government stimulus of investment markets and of Quantitative Easing in our own age is that these policies cannot create a stable equilibrium in the economy. In particular, as mentioned, they encourage the capital market and company directors to build too much capacity in those industries whose asset prices have been lifted by the policies.

The business cycle (when it used to be allowed to operate) traditionally kept capacity in the industrial and productive parts of our economies “in check”. When there were shortages of resources the prices of basic commodities would rise (e.g. during the Asian boom of the mid-1990’s). Investments were then made to take advantage of those higher prices, capacity increased and prices then fell (impacting first Asia in 1997 and Russia in 1998). A recession then traditionally occurred during which investment fell. Capacity then shrank relative to demand and the cycle could start again (in our example the China-led expansion that commenced in 2002).

Government interference in investment markets interrupts this self-regulation of investment activity. In particular QE increases returns on investment precisely at times investment would ordinarily be falling (i.e. in recessionary periods). We have created a mechanism that must, by design, create excess capacity in the economy.

This is the Achilles heel of Quantitative Easing. Far from causing inflation (which most of us thought would be the case when it was introduced in 2010 and thereafter) Quantitative Easing is creating the opposite effect, at least in the medium term. Over-investment, overproduction and therefore deflation.

9. A QE-led capacity boom has already become apparent in commodity industries

Overcapacity is already becoming apparent in investment-intensive and commodity producing sectors. The oil and gas, iron ore, coal, timber and bulk shipping industries all have real commodity prices near their long term lows (see graph), the effect of this overcapacity being reinforced by China’s slowdown.

Australian Coal Prices (USD / metric tonne)


Source: Quandl, IMF

Iron Ore (62%) China import Prices (USD / metric tonne)

Source: Quandl, IMF

Baltic Dry Index

Source: Zero Hedge

Excess capacity in commodity sectors becomes apparent faster than in other industries because their freely traded output prices collapse rapidly once there is expectation of too much supply.

If this is right the commodity industries may not turn out to be the worst affected. Investment should by now have ceased in these sectors, and the re-balancing process begun. Less transparent parts of the economy, where investment cycles are longer, may still be building significant over -capacity right now. Indeed it may be a number of years before the mistake is apparent.

10. Over-capacity is now spreading to property and corporate assets

I argued above there is just as much (if not more)***** reason for over-capacity to be built in the industrial and services sectors. It may be the behaviour will be most chronic in the property sector.

In the pound and dollar zone (which is well ahead of the Euro zone in their QE-led “expansions”) large investments have now commenced in commercial property and in residential property (especially in urban centres in Asia and UK). Adjacent sectors such as hotels, nursing homes and student accommodation are also booming.

Since QE was launched first in the UK (in 2010) it is no accident that London is now at March 2015 one of the largest building site in the world. London was the first place to get a QE boost to its property sector. And, if my case study of London flats is reliable, it may also be the first place to experience a QE prime property crash (to be fair, while the bear case for prime residential property seems obvious, strong migration flows – notably from European countries – may make a yield–driven crash less imminent for the lower range of housing, as in that sector usage (i.e. rental) demand is also growing strongly).

11. What about capacity expansion in the euro-zone?

At March 2015, QE has only just commenced in the Eurozone. It is therefore too early to see clear impacts on the real economy. However I expect European corporate and property investment will now expand. Even depressed economic areas such as Spain and Italy may now recover and even conceivably boom (especially if Eurozone QE I is followed by QE II as many economists are already urging). Just as in other regions the first impact of European QE will be to lift prices of existing assets. However, as they lift, arbitrage by investors is likely to eventually lead to new capacity being built both in corporate and in property sectors.

12. The eventual bust

In any country it is implemented QE will lift GDP growth for a period. As well as the income and wealth effects this will be a result of increased bank solvency, increased investor solvency, lower currencies and, eventually, the increased investment that is the focus of this Commentary. The subsequent failure of these policies and reversal of these gains will come in three steps:

1) QE will lift asset prices

2) while at the same time damaging the earnings of the sector that will benefit from it (because of overcapacity)

3) Over time, investors may then find themselves with higher and higher asset prices for less and less profitable assets, with the resulting economic picture beginning to resemble a Potemkin village.

Clearly this state of affairs cannot continue forever. Eventually enough sectors and investors (and citizens) will be hurt by the overcapacity so that some new policies are attempted.  It is possible that, as I argued in my last Commentary, governments may eventually adopt more 1970’s style interventions in the economy. Lowering taxes and/or increasing government spending on education and health and (hopefully – this finally is a good idea) green jobs. It is possible such a shift could be done “the hard way” with severe financial restructuring and a return to financial balance. However it is far more likely that the shift will be accompanied by significant (further) monetisation of the expenditures. Stimulation of these consumption expenditures are likely to be far more conventionally inflationary than government intervention in the investment markets. Especially now that the”taboo” on non-sterilisation of government expenditures has been broken i.e. especially since it is likely governments will print the money to fund these expenditures rather than (risking interest rate rises) by sterilising the spending with bond issuance (more accurately the executive arms of goverment will issue the bonds, but these will be purchased by their central banks with printed money, so the government as a whole will have printed the resources).

Thank you dear readers for struggling on to this point. In my next Commentary, (which I will try to get out in the next three weeks) I will make some comments on sectors I expect to hold their relative value in coming years. You will not be surprised to hear I continue to favour farmland, albeit it is currently looking rather boring compared to our more leveraged and “expandable” and therefore rapidly expanding urban property cousins.

I’ll leave you with a chilling prediction from the end of the General Theory.  Keynes became famous in the 1970’s because the unbalanced fiscal activism that was advocated in his name broke down. Citizens’ expectations “saw through” the illusion of “growth from government deficits” and stagflation resulted. We are now in a period where Keynes’ monetary recommendations are now highly fashionable. It may therefore be worth noting that he concludes the final chapter of his book by advocating:

“the euthanasia of the rentier, and, consequently, the euthanasia of the cumulative oppressive power of the capitalist to exploit the scarcity value of capital” (Chapter 24, Section II).

And how does he recommend we carry this out? By continuously lowering interest rates until so much investment is built that the marginal return (i.e. investment returns) of risk free capital is at zero. Now that Keynes’ followers in academia and in the central banks have implemented his extraordinarily bold and subversive ideas we investors had now better watch out and ensure we are now not caught up in his strongly desired aim: our euthanasia!


Forbes Elworthy

*2009 is the year I set up a “sustainable” fund management business focused on real assets. Keynes ideas on activist macro-economic management are qualified from time to time in his text with admonitions that the stimulus should be taken away once the economy has been rebalanced. Hence his many admirers never fail to excuse him every time activist economic management gets in to trouble (2008-09 being a great example). It was never the great man’s fault. It was the fault of venal politicians or incompetent central bankers for forgetting to take away the punch bowl.

**A wealth effect comes about when government asset buying makes asset owners feel richer and stimulates consumption, i.e. suppresses saving. A great example of this behaviour was in the “early years” of QE when falling interest rates let to  equity withdrawal by householders. . . In the “coming of age” period of QE the hoped-for suppression of saving and thereby stimulation of consumption has been muted. We have not proved eager to get out and flash the plastic any more, no matter how low interest rates go. To be fair it is hardly fair to fault Keynes’ wealth effect theory for not working post 2009. I think it is fairer to say it did not work only because it had worked so beautifully prior to that it had run out of dis-saving capacity.

+In the next chapter (16, Section IV) Keynes goes on to argue: “If I am right in supposing it to be comparatively easy to make capital-goods so abundant that the marginal efficiency of capital is zero [by lowering interest rates until investment surges, lowering overall returns], this may be the most sensible way of gradually getting rid of many of the objectionable features of capitalism. For a little reflection will show what enormous social changes would result from a gradual disappearance of a rate of return on accumulated wealth. A man would still be free to accumulate his earned income with a view to spending it at a later date. But his accumulation would not grow”.

***e.g. in Japan the  the Bank of Japan (BOJ) and affiliated state controlled pension funds are currently the largest investor in Japanese equities.

**** when a central bank makes sterilised purchases of assets it issues a similar amount of government debt into the markets so that the banking (and shadow banking) systems will not be a net recipient of liquidity. E.g. when a central bank seeking to support its own currency buys that currency, it will often sterilise that purchase in the domestic markets in order to lift interest rates and ensure the money supply does not grow. Similarly when it sells its currency to foreigners it may buy bonds in order to keep the money supply from shrinking. When a government systematically buys investment securities (including its own bonds) and does not sterilise then it is increasing the amount of “core money” in that economy’s economic system. Is this money printing? Yes it most certainly is. In fact it is not only “printing money” it is printing “core money” which would, if there was sufficient demand for liquidity, normally be taken up by the credit system and multiplied into significantly more “wide money”.

*****indeed possibly more given lack of transparency and discipline in directors suites of the new speculative sectors.