Larry Summers withdrew from the race to become the next Chairman of the Federal Reserve of United States on September 15, 2013. He was believed to be American President Barack Obama’s favourite candidate. (To read why he withdrew from the race click here)
The markets around the world immediately cheered his withdrawal. This happened primarily because Summers was widely seen to be what in central bank speak is termed as a ‘hawk’. A hawk is someone who is likely to raise interest rates and cut down on money supply.
Summers had said in April this year that “QE in my view is less efficacious for the real economy than most people suppose.” QE stands for quantitative easing and refers to the money that the Federal Reserve of United States, the American central bank, has been printing and pumping into the financial system, in the hope of getting the American economy up and running again.
The idea here is that by flooding the financial system with money, the interest rates will continue to remain low, thus encouraging people to borrow and spend more. With people spending more money, businesses will perform better, and the economic growth would come back.
Summers, it is believed, thinks that the government directly spending money through stimulus programmes, would have a greater impact on the economic growth in comparison to the Federal Reserve maintaining low interest rates by printing money and hoping that people borrow and spend more money.
The markets believed that Summers would stop printing money faster than Janet Yellen, the current Vice-Chairwoman of the Federal Reserve, who is now the front runner for the top job at the Federal Reserve.
Currently, the Federal Reserve prints $85 billion every month, which it pumps into the financial system by buying bonds. Ben Bernanke, the current Chairman of the Federal Reserve of United States, has indicated over the last few months that the Federal Reserve will go slow on money printing in the days to come.
This is a big worry for the markets. The idea behind all the money that is being printed has been that at low interest rates people will borrow and spend more money, and thus economic growth will return. But more than that what has happened is that investors have borrowed money available at very low interest rates and invested it in financial and other markets around the world.
This has led to big bubbles in these markets. As economist Bill Bonner writes “Works of art are selling for astronomical prices. High-end palaces and antique cars are setting new records. Is this reckless money hitting the stock market too?” Easy money is showing up in all kinds of places.
If the Federal Reserve goes slow on money printing, interest rates are likely to spike, making it difficult for investors who have enjoyed the benefits of the ‘dollar carry trade’ to continue enjoying it. Summers, the markets had come to believe, was more likely to stop money printing faster than any other candidate. And now that he is out of the race, the era of ‘easy money’ policies is likely to continue for a slightly longer period.
The situation needs a slightly more nuanced reading than this. As Martin Fridson writes on Forbes.com “The main, rather thin basis for portraying Summers as a hawk was a single remark he made in April about the Fed’s quantitative easing (QE) program: “QE in my view is less efficacious for the real economy than most people suppose.” This was not a major, formal policy statement, but a comment within an official summary of Summers’ remarks at a conference.”
Also, the Federal Reserve’s own research has showed as much. More than that even if a economist believes that quantitative easing hasn’t been effective, that doesn’t mean that he also believes that the Federal Reserve should go slow on it.
As Nobel Prize winning economist Paul Krugman writes in a recent column in the New York Times “One answer is the belief that these purchases…are, in the end, not very effective. There’s a fair bit of evidence in support of that belief.” The Federal Reserve puts the money that it prints into the financial system by buying bonds.
Even though, Krugman believes that quantitative easing hasn’t been very effective, he still recommends that it is important to continue with it. “Time for the Fed to take its foot off the gas pedal?” asks Krugman and then goes onto explain why that would not be the right thing to do.
He feels that any suggestion of the Federal Reserve going slow on money printing is going to lead to the long term interest rates in the United States going up. And this can’t be good for the overall American economy, which has just started to show some signs of revival.
Hence, the point here is that even though economists may understand that money printing has not been very effective, at the same time they may not want to go slow on it.
Summers also thinks that government stimulus programmes are likely to be more effective, there was not much that he could do about it. Any extra spending by the American government would mean it would have to borrow more money. This would be a problem given that the government has almost touched its debt limit of $16.7 trillion. As the Reuters reports “The government has been scraping up against its $16.7 trillion debt limit since May but has avoided defaulting on any bills by employing emergency measures to manage its cash, such as suspending investments in pension funds for federal workers.”
And more than that the Republicans don’t seem to be in any mood to let the government increase its spending. As an Associated Press news report points out “What’s more, massive fiscal stimulus is highly unlikely given opposition from congressional Republicans to increased spending.”
Given these reasons it is highly unlikely that Larry Summers would have been able to do anything dramatically different from what the Bernanke led Federal Reserve is currently doing or from what the Yellen led Federal Reserve(which is how it seems like right now) might do in the days to come. As Fridson writes on Forbes.com “My point is rather that the range of policy options will be limited for whoever steps into Ben Bernanke’s shoes. Barack Obama was never going to nominate a Fed chairman who would diverge from the narrow list of realistic choices regarding interest rates.”
(Vivek Kaul is a writer. He tweets @kaul_vivek)