Every central bank and their army of economists wonder why after all QE is so effective. It is indeed a curious proposition: the very idea that the exchange of some low yield low risk bonds for bank deposits is of major relevance defies reason. We all have learned that modern financial technology have made the world efficient. Prices should reflect risks, returns, not peculiarities of instruments. Financial intermediaries should be able, by unlashing the full power of derivatives engineering, to clear away those imbalances between the needs of capital providers and capital takers: what should be relevant is risk and return. If a company needs long term funding at floating rates but investors need long term fixed rate duration but short-term credit risk exposure, well some clever banker would find the way to match the needs of both parties. After all modern day investing is all about exposure: nobody takes serious commitment anymore to instruments, to cash constraints, and all that old stuff. It is so archaic. Barbaric relic before the age of the quants. However, when a central banker decides to swap duration, o boy, markets get nuts.
If the central banks’ army of economists does not have the answer, please do not suppose that I do. I wonder also, for years. Nevertheless, I am of a more pedestrian nature. Highbrow arguments are part of my youth. Social phenomena are usually simpler than what every theoretician imagine them to be. The pedestrian answer to the conundrum is that modern day financial markets is embarrassingly inefficient. It might be extremely efficient for the sophisticated things, but when it comes down to the very simple task of clearing away the duration trade of central bankers, it behaves like a child. The noble army should provide an answer for this real question. We do not the army here. When you ask the right question, that answer is usually trivial. It is inefficient because it goes against its incentives. The central banks are forcing into the global portfolios what no manager may dare to have. Bank deposits. After all, who can justify their fees if they hold bank deposits? Blasphemy. Your colleagues might manufacture jokes about you: have you seen that person over there, he holds bank deposits in his portfolio, what a weird fellow. Holding deposits is the ultimate sin of portfolio management. There is zero risk, zero return, no correlation, nothing. Liquidity? Who needs liquidity in modern finance? Everything is hypothecated after all.
There should be some final solution for this subversive instrument called bank deposits. There should be some place in the earth where we could hire them for them never to see daylight again? The humble retail investors, poor fellow, has no net equity left after the crisis. Corporations? Do not count on them. They are too busy buying back their own shares. When they held their cash outside U.S. jurisdiction by their account phantasies, they will not hold cash: they manage their liquidity like every professional does. Foreign central bankers? Do not count on them. They have statues, rules of engagement; they cannot trust theirs people wealth on unreliable banks.
Is there a chance that those weird monetary fellows got the idea right, but on the wrong angle? Is it possible that bank deposits change from hand to hand in an infinite loop of financial transactions, never settling down anywhere? Is there a chance that the velocity of money deposits is high and that the marginal supply of new deposits has an inflationary impact in asset prices due to barbaric monetary mechanisms?
MV=PQ. Common sense would suggest that since financial assets, contrary to physical assets, are prone to infinite loop of transactions, the adjusting variable to an MV shock would be Q. Higher amounts of unwilling deposits should give a boost to overall liquidity since deposits would change from hand to hand never finding its ultimate holder. However, there is no evidence of deeper liquidity in asset markets. Quite on contrary: asset markets seem obsessed with a buy and hope mentality. Bond managers are worried about the mismatch of liquidity present in the market place. If they face a reversal of fortunes, and money begins to flow away from their asset class they do not believe that current financial infrastructure is capable of clearing away the redemption driven sales. We all know what is happening here: the financial infrastructure of capital markets was severely handicapped by regulation after the subprime crisis. This might prevent the adjustment of MV to Q. The combination of more deposits, no demand for those deposits anywhere, and a financial infrastructure bottleneck preventing the typical infinite loop of transactions might lead to an asset price inflation contrary to every orthodoxy.
The argument is probably very flawed. Nevertheless, after years thinking every single day about the effectiveness of QE, this is my only proposal for a mechanism . If it is right, and I recognize that the odds are against it, since such an involved argument compounds lots of improbable hypothesis, but if it is right, it has a name. We all know how to call a process that raises prices due to market inefficiencies driven by central bankers
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