Raghuram Rajan, the governor of the Reserve Bank of India (RBI), gave a spate of interviews to international publications in early August 2014. In these interviews he talked about the financial markets bubbles that have sprouted up all over the world, due to Western central banks printing a lot of money over the last six years.
In an interview to the Time magazine Rajan said that central bankers had constantly “infused liquidity into the markets” (basically printed money and pumped it into the financial system) in order to ensure that interest rates continue to remain low. The idea was that at low interest rates people would borrow and spend more money and this would lead to economic growth.
But that doesn’t seem to have happened. Instead a lot of this money has been borrowed at low interest rates and has found its way into financial markets all over the world. As Rajan told the Central Banking Journal “The problems arising are not so much from credit growth, which is relatively tepid in the industrial markets and has been much stronger in emerging markets, but from asset prices due to financial risk-taking and so on.”
With so much “easy money” floating in the financial system, investors have borrowed money at very low interest rates and invested them in financial markets all over the world. This has led to prices of financial assets (shares, bonds etc) being pushed way beyond their fundamentals justify.
Or to put in simple English financial markets through large parts of the world are now in a “bubble” (a word that central bankers do not like to use) phase.
This is something that economists who run central banks have refused to see. As Rajan put it “ Unfortunately, a number of macroeconomists have not fully learned the lessons of the great financial crisis. They still do not pay enough attention – en passant – to the financial sector. Financial sector crises are not as predictable. The risks build up until, wham, it hits you.”
The trouble is that no one really can predict when exactly will these bubbles burst. Rajan admitted to as much in an interview to the Financial Times when he said “the truth is, nobody really knows where the next one will come.” Nevertheless, when these bubbles start to burst, there will be trouble of the kind that the world experienced in 2008, all over again. As Rajan put it “We are taking a greater chance of having another crash at a time when the world is less capable of bearing the cost.”
The question is why has been there so much faith among economists when it comes to printing money. George Cooper explains this very well in his book Money, Blood and Revolution. As he writes “[The] monetarists economists believed the money supply controlled economic activity and therefore monitored it to measure and forecast economic activity. When they found that their forecasts were verified they naturally assumed that their thesis – money controls economic activity – was proven.” Hence, when the economy was not doing well, it made sense to crank up the printing presses, print more money, increase the money supply and get the economy going again all over again. QED.
This was the formula followed in the aftermath of the financial crisis that broke out in September 2008, with the investment bank Lehman Brothers going bust. Trillions of dollars, pounds, yen and renminbi, have been printed and pumped into the financial systems all over the world. This policy in central banking terminology has been referred to as quantitative easing.
The question is how effective has quantitative easing really been? As Cooper puts it “These policies have had, at best, mixed results so far. It is sobering to contemplate that all of this money may have been spent based on a basic misunderstanding of cause and effect.”
And what is this misunderstanding? Cooper explains this through an example of an economist who starts to study the number of trucks travelling on a motorway system. After having studied this for a while, it becomes obvious to the economist that there is a relationship between “the number of trucks travelling in a given period and the subsequent reported level of economic activity”. Hence, the economist draws the conclusion that road freight activity is a key driver of economic activity. So far so good.
This economist then goes on to found the freightist school of economics. The school then lobbies the government and policies that encourage the movement of trucks moving goods on the roads, are put in place.
Taxes are cut and schemes to subsidise the purchase and running of trucks are introduced. The first results of this experiment are positive as the economy grows. This leads to the government directly subsidising freight journeys. And this is where the problem starts. As Cooper puts it “Eventually truckers start driving freight up and down the country just to harvest subsidies. The economy stops growing but the freight statistics shoot through the roof. The relationship between economic activity and road freight breaks down.”
A basic mistake has been made here. “The freightist school has mistaken the direction of the causality between road freight and economic activity. Stronger economic activity causes more road freight but more road freight does not necessarily cause more economic activity,” writes Cooper.
A mistake along similar lines has been made by central banks all over the world, during the last few years. When economic activity picks up, money supply picks up as well. But that does not mean that the level of money supply can be manipulated to increase economic activity. As Cooper summarises it “Money is a measure of credit, and credit, like truck journeys, is created and destroyed according to the prevailing economic activity. Money supply, in its various forms, is an excellent measure of economic activity when left alone. But it cannot be used as an instrument to control the economy.”
In Cooper’s example we saw truck drivers driving freight up and down the country simply to harvest subsidies. Over the last six years, investors have worked along similar lines. They have borrowed money at very low interest rates and invested them in financial markets all over the world. And this has led to huge bubbles, which will burst in the years to come.
The column originally appeared in the Wealth Insight magazine for Sep 2014
(Vivek Kaul is the author of Easy Money: Evolution of the Global Financial System to the Great Bubble Burst. He can be reached at [email protected])