The Federal Reserve of the United States, the American central bank, has been rapidly expanding its balance sheet since late 2008. As on November 13, 2013, the size of the Fed’s balance sheet was at $3.907 trillion.
Now compare this to the size of the Fed’s balance sheet as on September 10, 2008, when it stood at around $940 billion. The investment bank Lehman Brothers went bust as on September 15, 2008, which led to the start of the current financial crisis.
Since late 2008, the Federal Reserve has been printing dollars. It has been pumping these dollars into the financial system by buying financial securities like American government bonds and mortgage backed securities. Currently, the Fed buys $85 billion worth of financial securities every month.
The securities that the Federal Reserve buys are reflected as assets on its balance sheet. Hence, the balance sheet of the Federal Reserve has increased in size by a whopping 316% in a little over five years. In fact, the balance sheet of the Federal Reserve should touch the size of $4 trillion sometime next month, given that it continues to print dollars and buy financial securities worth $85 billion every month.
At $4 trillion, the Federal Reserve’s balance sheet will be nearly 25.5% of the US gross domestic product of $15.68 trillion in 2012. In fact, if the Federal Reserve continues to print money at the rate it is currently, its balance sheet will cross $5 trillion in a year’s time. These are fairly big numbers that we are talking about.
The idea behind printing money was to ensure that there was enough money going around in the financial system and hence, the interest rates continued to stay low. At low interest rates people were more likely to borrow and spend, and this would help revive business growth and in turn economic growth.
But that hasn’t turned out to be the case and economic growth continues to remain low in United States and much of the Western world. Also, the prevailing belief seems to be that demand can be created by keeping interest rates low for a long period of time.
As investment newsletter writer and hedge fund manager John Mauldin writes in his latest report The Unintended Consequences of ZIRP released on November 16, 2013 “The belief is that it is demand that is the issue and that lower rates will stimulate increased demand (consumption), presumably by making loans cheaper for businesses and consumers. More leverage is needed! Butcurrent policy apparently fails to grasp that the problem is not the lack of consumption: it is thelack of income.”
People borrow and spend money when they feel confident about the future. Right now, they just don’t. A major reason for this is the fact that United States and large parts of Europe are in the midst of what Japanese economist Richard Koo calls a balance sheet recession.
In a balance sheet recession a large portion of the private sector, which includes both individuals and businesses minimise their debt. When a bubble that has been financed by raising more and more debt collapses, the asset prices collapse but the liabilities do not change.
In the American context what this means is that people had taken on huge loans to buy homes in the hope that prices would continue to go up for perpetuity. But that was not to be. Once the bubble burst, the housing prices crashed.
This meant that the asset (i.e. homes) that people had bought by taking on loans, lost value, but the value of the loans continued to remain the same. Hence, people needed to repair their individual balance sheets by increasing savings and paying down debt. This act of deleveraging or reducing debt has brought down aggregate demand and has thrown the economy in a balance sheet recession.
Koo feels this is what has been happening in the United States where people have been paying down their debts, by increasing their savings. In mid 2005, when the housing bubble was at its peak, an average American was saving around 2% of his or her personal disposable income. This has since jumped to nearly 5%. In this scenario, it is unlikely that many people would want to borrow more, even if interest rates continue to remain low.
Individuals may not be borrowing as much as the American government expected them to, institutional investors have more than made up for it. Borrowing dollars at close to zero percent interest rates, they have invested money in financial markets all over the world. The Dow Jones Industrial Average, America’s premier stock market index, crossed a level of 16,000 points for the first time yesterday. The BSE Sensex also continues to trade close to 21,000 points, despite the Indian economy being in a bad shape.
Since the beginning of this year, the foreign institutional investors have invested Rs 71, 308.51 crore, in the Indian stock market. This is a clear impact of the easy money policy being run by the Federal Reserve. During the same period the domestic institutional investors have sold stocks worth Rs 62,573.45 crore. These are clear signs of the stock market being in the midst of a bubble.
The Federal Reserve can keep printing as many dollars as it wants to, given that there is no theoretical limit to it. Also, money printing is not having the kind of impact it was expected to have to create economic growth. At the same time it has led to financial market bubbles all over the world.
As Mauldin puts it “they also know they cannot continue buying $85 billion of assets every month. Their balance sheet is already at $4 trillion and at the current pace will expand by $1 trillion a year. Although I can find no research that establishes a theoretical limit, I do believe the Fed does not want to find that limit by running into a wall. Further, it now appears that they recognize that QE(quantitative easing or the fancy name economists have given to the Federal Reserve printing money) is of limited effectiveness.”
The trouble is that if the Federal Reserve decides to go slow on money printing, there will be a sell off across financial markets all over the world. And that will have fairly negative consequences for the US and large parts of the world.
Also, the Federal Reserve has more or less run out of the tools that it has at its disposal to revive the American economy. As Ray Dalio of Bridgewater pointed out in a recent note. “The dilemma the Fed faces now is that the tools currently at its disposal are pretty much used up, in that interest rates are at zero and US asset prices have been driven up to levels that imply very low levels of returns relative to the risk, so there is very little ability to stimulate from here if needed. So the Fedwill either need to accept that outcome, or come up with new ideas to stimulate conditions,” writes Dalio.
The Federal Reserve is in a catch 22 situation right now. Should it continue to print money? Should it go slow? This is a question that Janet Yellen, the Federal Reserve Chairman in waiting, needs to answer.
The article first appeared on www.firstpost.com on November 19, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)