One of the measures that has been floated by central banks to stimulate the economy has been the idea of buying stocks. It would quantitative easy to the next level. In this post, we discuss the potential economic, financial, societal consequences of central banks buying stocks.
Content
- Introduction
- 10 Consequences of Central Banks Buying Stocks
- How to Invest if Central Banks start Buying Stocks
Introduction
After the 2008 financial crisis, most Western economies, highly indebted and unwilling to implement significant reforms to reduce their budget deficits, began to implement unconventional monetary policies.
Such policies consisted of central banks buying government debt. This was done so governments could continue to borrow freely without being at risk that investors, concerned about the poor state of the country’s public finances, would refuse to finance the government and push its borrowing costs higher.
However, that was sold as being a tool to stimulate the economy. And what was sold as a temporary measure became the new normal for over 15 years.
In addition to that, many Western central banks expanded their debt purchases by buying mortgage-backed securities and corporate bonds. This was done to expand the monetary supply and reduce interest rates for households and citizens.
Japanese Central Bank Buying Stocks since 2013
In 2013, the Bank of Japan (BOJ) went a step further and started buying stocks. Less than a decade later, the BOJ already owned more than 5% of the entire Japanese stock market.
In 2020, senior officials of the Federal Reserve Bank of the United States and the European Central Bank began to float the idea that their central banks would also be interested in buying stocks.
Unfortunately, such news was received almost positively by the press, without serious questioning about the potential consequences of central banks buying stocks and becoming major shareholders of the largest corporations in the world.
This is precisely what we will do in this post. We will analyze the consequences that are expected, both in the short-term as well the long-term, if Western central banks do eventually decide to start buying stocks.
We will focus on the idea of central banks buying stocks from their own home country. In other words, the Bank of Japan buying Japanese stocks, the ECB buying Eurozone stocks or the Federal Reserve Bank buying US stocks.
It is important to make that clarification since the Swiss National Bank (SNB) is a major shareholder in multiple foreign corporations. However, the SNB has been acquiring foreign stocks as a tool to prevent is own currency, the Swiss Franc, from appreciating.
10 Consequences of Central Banks Buying Stocks
As you will see, the consequences we will analyze are financial, economical and societal:
1) Stock Market Bubble
The first consequence of central banks buying stocks is that it would create a stock market bubble. In general, bubbles form when investors believe that risk does not exist and high returns are guaranteed.
For this reason, if investors knew that central banks were going to buy shares on a regular basis and intervene in the markets if there was a crash, risk would no longer be considered. Since the central bank has unlimited credit, they can push stock prices as high as they want.
Something very similar happened in the bond market since central banks began buying sovereign debt. Countries that, due to their high level of public debt and deficits, previously had to offer high interest rates to investors to borrow money, were later able to get financing at 0% or even negative interest rates.
Because investors expected central banks to not allow the price of these bonds to drop, as that would lead to an increase in financing costs for these countries, they just continued to buy that debt. And many of these countries were effectively bankrupt.
Therefore, if central banks start buying stocks in the future, it is almost certain that stock prices are going to rise dramatically.
As we have previously mentioned, the Bank of Japan began buying Japanese stocks in 2013. It did so by buying stock ETFs tracking the main stock indices in the country.
When the Bank of Japan announced its new “monetary stimulus” program in late 2012, the Nikkei 225 index was trading around 9,000 points. 8 years later, it had climbed to almost 27,000 points. A 200% in increase in 8 short years.
2) Greater Wealth Inequality
Another consequence of central banks buying stocks is that it would lead to a widening of wealth inequality. In fact, the policies that have been applied since the 2008 financial crisis have already led to extreme levels of wealth inequality.
That is why it is so hypocritical to hear a politician say that expansionary monetary policies must be pursued, while at the same time mentioning that measures have to be taken to combat growing inequality.
If central banks bought stocks, we could expect stock prices to rise. That would disproportionately benefit those individuals who already own stocks.
Billionaires would see their wealth increase significantly. The middle classes, though they may have modest stock or real estate investments, would face a significant increase in their cost of living due to the inflation caused.
And when it comes to the working poor, they would have to face a much lower standard of living. Since they own no assets, they would have no way to offset the inflation rates in their day-to-day expenses.
3) Less Social Mobility
A consequence of greater wealth inequality is that it leads to less social mobility.
Two conditions are necessary for there to be social mobility. One is that people who are at not wealthy should be able to succeed professionally or in business if they add value to society. That makes it possible for them to increase their income to higher levels than their parents.
The second condition is for those individuals to be able to convert that higher income into real wealth by acquiring assets. These assets can be in the form of stocks, real estate, gold, etc.
But if central banks have been acquiring all sorts of assets, pushing their prices higher, it becomes more difficult to access the same standard of living and wealth that was possible in the past. As a consequence of that, for example, fewer successful people from more modest backgrounds are able to move to affluent neighborhoods.
Less social mobility means less meritocracy. And the lack of meritocracy leads to a society with unproductive values.
4) Less Economic Growth
A stagnant economy is one in which companies have stopped innovating and, in many cases, are unable to generate profits or even service the interest on their debt.
But if a company is unable to generate long-term profits, it is because the goods and services it offers to the marketplace are not demanded enough by society. This means they are not generating enough value.
In a capitalist economy, these types of companies would disappear sooner or later, as access to capital would disappear and they would need to shut down. While this would be painful in the short term, it would make way for newer companies that can ultimately succeed and increase the standard of living for society.
This process is known as creative destruction and was identified by Schumpeter. Crises can be a trigger for innovation, new businesses and a better standard of living for all in the long term.
Yet in an economy where central banks decide who receives capital and is able to survive, creative destruction does not exist. Even if a company was unable to generate profits and be self-sustaining, it would continue to receive capital inflows from the central bank as long as it was listed on the stock exchange.
In fact, some executives at large Japanese corporations have acknowledged that they now have a smaller incentive to work hard to increase profitability. Prior to 2013, profits were necessary for the stock price to rise. Since the BOJ started buying stocks, that is no longer the case.
5) More Unstable Financial System
Although one of the justifications we hear from central banks for buying stocks is to improve stability in the financial system, such measures would make financial markets less stable.
Financial markets adapt constantly based on expectations for economic growth, inflation, interest rates, monetary policy, trade policy, etc. All these metrics are crucially important.
In a free market economy, if economic growth is strong, the stock market tends to rise. If inflation goes up, interest rates and the price of gold tend to rise. If there is a recession, stock markets and interest rates drop.
However, in a market where central banks are the most important factor, fundamental data ceases to matter. Economic growth, inflation, recessions, etc. become mostly irrelevant. What matters is guessing correctly that central banks will do one thing or another.
At the same time, the central bank’s stock purchases would predispose investors to assume that stock prices would rise regardless of what happens in the economy. That would lead to more investors using leverage to invest more aggressively.
As a result, financial markets become dependent on the decisions taken by a group of bureaucrats, exposing everyone to unanticipated risks.
6) Less Wealth for Citizens
A monetary policy of this type would cause the level of wealth in the hands of private citizens to shrink. We should not confuse money with wealth to understand this point.
Wealth refers to the goods and services that are produced in the economy, as well as the assets that are part of it. Thus, the wealth of a society is its companies, many of them listed on the stock exchange and in which we can buy shares, its real estate, cars, gold, works of art, etc.
Money, whether it is US Dollard, Euros, Pesos Pounds, or Yen, has no intrinsic value. Its value depends exclusively on someone else being willing to accept it in exchange for something with value.
If central banks buy stocks, they do so with money created out of thin air. They type into a computer ledger how much money they want to create and use it to buy stocks. What just happened is that the central bank now owns a real asset (stocks represent ownership in real companies) in exchange for something that has no intrinsic value.
As a result, there is now more fiat money in the hands of society but fewer assets to buy. The aggregate wealth in the hands of private citizens has been diminished.
The end result of such policies is that eventually society becomes poorer. In addition, inflation goes up, pushing up the cost of living and increasing financial hardship on the poorest of society.
7) Nationalization of the Country’s Assets
If the level of wealth in the hands of the population decreases, the level of wealth in the hands of government and its institutions increases. And therein lies the greatest threat of these policies at the economic level.
Sovereign and corporate debt purchases by central banks already had extremely harmful effects. But luckily, bondholders do not get to decide how a company is run.
However, shares represent direct ownership and control over corporations. If the central bank buys stocks, what is really happening is a nationalization of the country’s assets. Assets are no longer in the hands of the private sector but controlled by politicians and bureaucrats in public sector.
Furthermore, the process by which this would have occurred could be defined as expropriation or confiscation. Since the central bank can create as much money as it wants, it is truly giving nothing to society as a whole in exchange for those stocks.
Therefore, one of the consequences of central banks buying stocks is that the economy may end up looking like in the former Soviet bloc. Large and medium-sized companies were all controlled by the state.
The consequences for our standard of living and fairness in our society would be extremely negative.
8) More Power in the hands of Politicians and Bureaucrats
As a result of what we discussed in the previous point, the power of those in control of government would increase. They would be able to influence how companies are run.
If a company is in the hands of a capitalist, the most important goal is to make a profit. To do this, the company must offer goods and services that are demanded by the population. Otherwise, that company would eventually disappear. That is why capitalism leads to a higher standard of living for society in the long run.
Conversely, if the government, or a government institution like the central bank, takes decisions on behalf of a company, creating good products and services ceases to be the main objective. Because a politician or bureaucrat is in charge, personal and ideological motives become more important. The risk of corruption becomes a big threat.
We only need to take a look at communist countries to find out how things would end up.
9) Loss of Freedom
A government with too much power usually translates into a significant loss of freedom for the population. This applies to all types of freedoms, including economic and financial freedom.
An economy in which the government and its institutions own most of the means of production is an economy in which the laws of supply and demand cease to apply in many respects.
The market, generally composed of free producers and consumers, is no longer able to decide what should be produced, how and in what quantities. There is no longer a mechanism by which companies must adapt and improve. In such a scenario, the economic freedom of entrepreneurs and workers is greatly diminished.
How is a small entrepreneur supposed to compete with a big corporation that does not need to make a profit?
At the same time, a government with the power to decide how companies should operate, could also up deciding how its citizens should live.
Such losses of freedom begin by fixing the prices of some products considered strategic or too important. Because the measures adopted fail, as they always have done, government chooses to impose more extreme regulations, making the problem bigger.
Eventually, the entire economic system is in jeopardy.
10) Centrally Planned Economy
The logical consequence of such measures would be the eventual establishment of a centrally planned economy, very similar to that of a communist country, and the massive impoverishment of the population.
While such an extreme scenario would not happen for several years, it is where these types of policies would eventually take us if the population did not oppose them.
While that may sound alarmist, it is worth bearing in mind that banks started to buy sovereign debt over a decade ago as a temporary measure. This has led to much larger governments, with the power to spend without any checks and balances, and a much weaker economy.
Therefore, we must ask ourselves where such policies could take us. At the end of the day, if the central bank starts buying stocks, it could even end up buying housing stock and thereby nationalizing a greater portion of the country’s assets.
How to Invest if Central Banks start Buying Stocks
Let us now discuss how we should invest if central banks started buying stocks. We will talk about short-term and long-term investments.
In the short term, buying stocks would be a good idea. If we know that the central bank is going to push stock prices higher, we would want to be positioned to benefit from that.
While I would not recommend using leverage, since the level of uncertainty in the market would be higher, that could magnify our capital gains.
If we focus more on the long term, we should acquire safe-haven assets that are difficult for governments and central banks to buy. That means buying physical gold and silver, and also cryptocurrencies like Bitcoin. These types of assets would make it possible for us to safeguard our wealth.
Obviously, if we ended up in a centrally planned economic system with a significant loss of freedoms, we would probably want to emigrate to another country. But this is another discussion altogether.
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