Of Japanese deflation, global money printing and quest for economic growth

3D chrome Dollar symbolThe human obsession with economic growth has perhaps been best captured by E.B. White in an essay called A Report in January published in January, 1958. The essay is a part of a book titled Essays by E.B. White.

In this essay White writes: “The theory is that if you shoot forty thousand deer one year you aren’t getting ahead unless you shoot fifty thousand the next, but I suspect there comes a point where you have shot just exactly the right number of deer. Our whole economy hangs precariously on the assumption that the higher you go the better off you are, and that unless more stuff is produced in 1958 than was produced in 1957, more deer killed, more automatic dishwasher installed…more heads aching so they can get the fast fast fast relief from a pill, more automobiles sold, you are headed for trouble, living in danger and maybe in squalor.”

This obsession with economic growth has been at play in the aftermath of the financial crisis which broke out in September 2008, when the investment bank Lehman Brothers went bust. The central banks and governments all around the Western world unleashed an era of easy money, by printing money and maintaining low interest rates.

This was done in the hope of people borrowing and spending more. So, with interest rates remaining low, people were likely to buy more homes, more cars, more consumer goods and so on. And in the process there would be more economic growth.

Most central bankers did not want the Western world to turn into another Japan. Right through the eighties, the Japanese stock market and the real estate market had huge bubbles. These bubbles burst towards the end of the eighties. And it is widely believed by economists that the Japanese economy never recovered from this. It entered into an era of deflation (the opposite of inflation, when prices fall).

When the economy is in a deflationary scenario, people tend to postpone their purchases in the hope of getting a better deal. Once this starts to happen, the business earnings start to fall. This leads to businesses cutting costs by firing people among other things. All this impacts economic growth. Businesses cut prices further, in the hope of persuading more people to buy things. And so a deflationary cycle sustains itself.

This is something that Western central bankers wanted to avoid. And this led to the unleashing of an era of easy money, which continues. In fact, as Raghuram Rajan, the governor of the Reserve Bank of India, recently said in a speech: “The canonical example here is Japan, where many are persuaded that the key mistake it made was to slip into deflation, which has persisted and held back growth.”

There is a great fear that what has been happening in Japan will happen in large parts of the Western world as well, if central banks don’t act and flood their financial systems with money.

In fact, Andrew Hallande, the Chief Economist of the Bank of England recently suggested the elimination of paper money. This would allow central banks to impose negative interest rates (which some central banks have already tried in Europe). When there is a negative interest rate on deposits, the bank will charge people for depositing their money in a bank account. This will lead to people spending their money instead of keeping it in a bank account, where its value will fall because of a negative interest rate. The spending that follows because of negative interest rates will lead to economic growth.

This is only possible if there is ‘only’ digital money and no paper money. If banks apply negative interest rates as of now, people can simply withdraw that money in the form of paper money and keep it under their mattresses or wherever they want to. Hence, Hallande’s suggestion of only digital money to revive economic growth.

Such suggestions come from the fear of deflation. But the question is are things in Japan as bad as they are made out to be? James Rickards in his book The Death of Money, talks about a speech where he heard a former deputy finance minister of Japan, Eisuke Sakakibara, speak.
He [i.e. Sakakibara] made the often-overlooked point that because of Japan’s declining population, real GDP per capita will grow faster than real aggregate GDP.”

What this basically means is that because of declining population in Japan, even if the overall Japanese economy does not grow or grows at a very slow pace, there will still be more economic growth per person in Japan.

As Rickards writes: “Far from a disaster story, a Japan that has deflation, depopulation, and declining nominal GDP can nevertheless produce robust real per capita GDP growth for its citizens. Combined with the accumulated wealth of the Japanese people the condition can result in well-to-do society even in the face of nominal growth that would cause most central bankers to flood the economy with money.”

In fact, Rajan made a similar point in his recent speech. As he said: “A closer look at the Japanese experience suggests that it is by no means clear that its growth has been slower than warranted let alone that deflation caused slow growth. It is true that after its devastating crisis in the early 1990s, Japan may have prolonged the slowdown by not taking early action to clean up its banking system or restructure over-indebted corporations. But once it took decisive action in the late 1990s and early 2000s, Japanese growth per capita or per worker looks comparable with other industrial countries.”

This becomes clear from the accompanying table:

In fact, one of the fears of deflation, as explained earlier, is that it leads to unemployment. Nevertheless that doesn’t seem to be the case in Japan. As Rajan said: “Japanese unemployment has averaged 4.5% between 2000-2014, compared to 6.4% in the US and 9.4% in the Euro area during the same period. In part, the Japanese have obtained wage flexibility by moving away from the old lifetime unemployment contracts for new hires to short term contracts. While not without social costs, such flexibility allows an economy to cope with sustained deflation

So, it’s time that central bankers take a re-look at the entire Japanese experience and revise their views on the idea of deflation.

Meanwhile, Japan seems to be getting ready for more money printing. As they say, the more things change, the more they remain the same.

The column originally appeared on October 9, 2015 on The Daily Reckoning 

What we can learn about the financial crisis from Arab Spring & First World War

I don’t know how many of you have heard of this man called Mohammed Bouazizi. Honestly, even I hadn’t heard about him until a few days back.
On December 17, 2010, this 26 year old set himself on fire and died. And why did he do that?

His story is recounted by Philip Tetlock and Dan Gardner in their new book Superforecasting—The Art and Science of Prediction. Bouazizi was a Tunisian who sold fruits and vegetables on a handcart. On December 17, 2010, the police approached him and took away his weighing scales on the pretext that he had broken some regulation. Bouazizi knew that this was a lie and the police basically wanted money.

He went to the town office to complain. He was told that the official he wanted to meet was busy. Bouazizi left on being told this, feeling humiliated and powerless. He went and got some fuel, poured it over himself and set himself on fire.

This sparked protests in Tunisia and the police as expected responded with brutality. Bouazizi died on January 4, 2011. After this, the unrest in Tunisia grew. As Tetlock and Gardner write: “On January 14, 2011, [President Zine El Abidine] Ben Ali fled to a cushy exile in Saudi Arabia ending his twenty-three year kleptocracy.”

Protests soon spread to Egypt, Syria, Jordan, Kuwait and Bahrain. The Egyptian dictator Hosni Mubarak was also forced to leave office. “This was the Arab Spring—and it started with one poor man, no different from countless others, being harassed by police, as so many have been, before and since, with no apparent ripple effects,” write Tetlock and Gardner.

An event like this couldn’t have been predicted. Nevertheless, in the days to come the Middle East experts came up with their own explanations for the Arab Spring. They talked about high-unemployment and poverty. They talked about corruption and repression and how all these factors led to the Arab Spring.

However, all these factors did not appear overnight and had been around for a while. As Tetlock and Gardner write: “An observer could have drawn exactly the same conclusion the year before. And the year before that. Indeed, you could have said that about Tunisia, Egypt and several other countries for decades. They may have been powder kegs but they never blew—until December 17, 2015, when the police pushed that one poor man too far.”

Something similar happened in June 1914 as well, more than 100 years back. Mark Buchanan recounts this story in Ubiquity—The Physics of Complex Systems.

At around 11 AM on June 28, 1914, a driver of an automo­bile carrying two passengers in Sarajevo made a wrong turn. The car wasn’t supposed to make this turn and leave the main street. But due to the mistake of the driver it ended up in a narrow lane and stopped right in front of a Gavrilo Princip, a 19-year-old student.

But that wasn’t Princip’s only identity. He was also a member of the Serbian terrorist organization Black Hand. Princip couldn’t believe his luck. He drew out his pis­tol and fired twice killing the two passengers in the car. Prin­cip had recognized them and gone ahead and pulled the trigger. They were Archduke Franz Ferdinand and his wife Sophie of the Austro-Hungarian Empire.

The assassination led to a series of events in a politically fragile Europe and started what was first known as the Great War and later came to be known as the First World War.

Very soon Austria used the assassination as a reason to invade Serbia. Russia guaranteed protection to the Serbs. Soon Germa­ny got involved and offered to be on Austria’s side if the Russians supported the Serbs. France and Britain also got involved. And a few years later the United States also entered the war. A chauf­feur’s mistake triggered a series of events which led to one of the biggest armed confrontations that mankind had ever seen.

More than 100 years later, historians are still writing books on what started the First World War. History is replete with many such examples.
The start of the Arab Spring as well as the First World are excellent examples of the butterfly-effect. The term was coined by the American meteorologist Edward Lorenzo in 1972. As Dan Gardner writes in Future Babble—Why Expert Predictions Fail and Why We Believe Them Anyway: “Lorenzo…came up with a slightly more down-to-earth image to capture the idea of minuscule changes making a big difference in outcomes: The flutter of a butterfly’s wings in Brazil, he said, could ultimately cause a tornado in Texas. The label “Butterfly Effect” has stuck ever since.”

How does the Butterfly effect fit into the context of the Arab spring? As Tetlock and Gardner write: “If that particular butterfly hadn’t flapped its wings at that moment, the unfathomably complex network of atmospheric actions and reactions would have behaved differently, and the tornado might never have formed—just as the Arab Spring might never have happened, at least not when and as it did, if the police had just let Mohammed Bouazizi sell his fruits and vegetables that morning in 2010.”

The same can be said about the First World War. If Princip hadn’t carried out the assassination, the First World War would might never happened, at least not “when and as it did”.

So what can we learn from these examples? The current financial crisis is also an excellent example of the butterfly effect. The investment bank, Lehman Brothers, went bust on September 15, 2008. Lehman Brothers was the fourth largest investment bank on Wall Street. Individually, it looked like a big event, but it turned out to be very small in comparison to what followed.

The very next day, AIG, the biggest insurance company, had to be nationalized by the American government. This was followed by a spate of financial institutions across the United States as well as Europe getting into trouble. This led to the central banks as well as the governments coming to the rescue of these financial institutions.

While, many economists had predicted the crisis (and some had been predicting for a very long time), almost no one got the timing right. And any prediction without a time-frame is essentially useless, even if it eventually turns out to be right.

The collapse of Lehman Brothers led to the start of the financial crisis. Now more than seven years later, the underlying problems that led to the start of the financial crisis still remain the same. The banks are too big. And they continue to be heavily financialized. As John Kay writes in Other People’s Money:

“Lending to firms and individuals engaged in the production of goods and services – which most people would imagine was the principal business of a bank – amounts to about 3 per cent of…total.”

What this means that trading in financial securities continues to be the principal business of banks. And this was one of the major reasons behind the financial crisis.

This leads me to believe that the current financial crisis hasn’t come to an end. I can also say with great confidence that the next round of the financial crisis will also be a very good example of the butterfly effect, where one small event will start the financial fire all over again. This will force the governments and the central banks to become firefighters all over again.

The only thing I don’t know is, when the next round of the financial crisis will start. Neither does anyone else. And if they do claim to know, they are lying.

The column originally appeared on The Daily Reckoning on Sep 29, 2015

Phillip’s curve: The economic theory that Janet Yellen is stuck with

The interest rate setters at the Federal Reserve of the United States, the American central bank, have decided not to raise the federal funds rate, for the time being. The federal funds rate is the interest rate at which one bank lends funds maintained at the Federal Reserve to another bank on an overnight basis. It acts as a sort of a benchmark for the interest rates that banks charge on their short and medium term loans.

The federal funds rate has been maintained in the range of zero to 0.25% in the aftermath of the financial crisis which started in September 2008. The Federal Reserve has been aiming for an inflation of 2%.

The measure of inflation that the Fed looks at is the core personal consumption expenditure (PCE) deflator. The deflator in July 2015 was at 1.2% in comparison to a year earlier, which is significantly lower than the 2% rate of inflation that the Federal Reserve is aiming for.

The statement released by the Federal Reserve on Sep 17, 2015 said: “Inflation has continued to run below the Committee’s longer-run objective, partly reflecting declines in energy prices and in prices of non-energy imports…Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability…The Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further.”

Before getting into analysing this statement, I would like to go back into history and talk about something known as the Phillips curve. The Phillips curve was the work of an economist called William Phillips. Phillips was a New Zealander by birth. At the end of the Second World War, he landed at the London School of Economics (LSE).

As Tim Harford writes in The Undercover Economist Strikes Back — How to Run — Or Ruin — An Economy: “As a part of his work on economic dynamics, Phillips gathered data on nominal wages (a good proxy for inflation) and unemployment, and plotted the data on a graph. He found a strong and surprisingly precise empirical relationship between the two; when nominal wages were rising strongly, unemployment would tend to be low. When nominal wages were falling or stagnant, unemployment would be high.”

There was great pressure on Phillips to publish something so that he could be offered a professorial chair at the LSE. As Harford points out: “So Phillips, under pressure from his colleagues to publish something, dusted off his weekend’s work and turned it into a paper. He was unimpressed with his own work, later describing it as ‘a rushed job’. [His] colleagues, ever eager to help his career along, got the paper published in LSE’s journal Economica, under the title ‘The

Relationship between Unemployment and the Rate of Change of Money Wages in the United Kingdom 1861-1957.

The research paper was published in 1958 and “became the most cited academic paper in the history of macroeconomics”. The inverse relationship between unemployment and wages was explained by the fact that during periods of low unemployment, companies would have to offer higher wages in order to attract prospective employees. And higher salaries would mean higher wage inflation.

Over the years, the phrase wage inflation was replaced by simply inflation, even though they are not exactly the same. Hence, during the period of the low unemployment, inflation is high and vice versa, is something that many economists came to believe.

The Phillips curve became extremely popular over the years. As Harford writes: “The reason the ‘Phillips curve’ became so popular is that other economists – notably Paul Samuelson – championed the idea that policymakers could pick a point on the curve to aim for. If they want wanted to reduce unemployment, they’d have to tolerate higher inflation; if they wanted to get inflation down, they’d have to accept higher unemployment.”

But that is not how things always work. Over the last few years, the official rate of unemployment in the United States has come down. As of July 2015 it stood at 5.3% of the total civilian labour force. In July 2014, the number had stood at 6.2%. Even though the unemployment data for August 2015 is available I have considered July 2015 data simply because the inflation data for August 2015 is not available as yet.

What has happened on the inflation front? In July 2015, the core PCE deflator was at 1.2 %. In comparison in July 2014, the core PC deflator was at 1.7%. Hence, what is happening here is the exact opposite of what the Phillips curve predicts.

As official unemployment has fallen, the inflation instead of going up, has fallen as well. Nevertheless, the faith in the Phillips curve still remains high. As Yellen said on Thursday: “We would like to bolster our confidence that inflation will move back to 2%. And of course a further improvement in the labor market does serve that purpose.”

This is nothing but a restatement of the Phillips curve—as the rate of unemployment falls further, the rate of inflation will move towards 2%. The question is will that happen? From the way things have gone up until now, the answer is no.

The Harvard economist Larry Summers in a recent blog explains why the Phillips curve does not work. As he writes: “The Phillips curve is so unstable that it provides little basis for predicting inflation acceleration.  To take just two examples — first, unemployment among college graduates is 2.5 percent yet there is no evidence that their wages are accelerating. And unemployment in Nebraska has been below 4 percent for the last 3 years and growth in average hourly earnings has been basically constant at the national average level.”

Also, if Yellen continues to believe in the Phillips curve, there is no way she can be raising the federal funds rate, any time soon.

Further, the Federal Reserve is now worried about how things are panning out in China as well. As Yellen said: “The outlook abroad appears to have become more uncertain of late. And…heightened concerns about growth in China and other emerging market economies have led to volatility in financial markets.”

What this means is that Yellen feels that China is likely to devalue its currency more in the time to come to fire up its exports. A further devalued yuan will allow Chinese exporters to cut prices of the goods that they export to the United States.

These cheaper imports into the United States are likely to push down the rate of inflation further. This means that the rate of inflation is unlikely to get anywhere near the Federal Reserve’s 2% target anytime soon. Also, it will take time for the Federal Reserve (as well as others operating in the financial markets) to figure out the extent of China’s economic problem. Given this, I don’t see the Federal Reserve raising interest rates, any time soon. At least, not during the course of this year.

In the Daily Reckoning dated March 20, 2015, I had said Janet Yellen’s excuses for not raising interest rates will keep coming. I don’t see that changing anytime soon.

The column originally appeared in The Daily Reckoning on Sep 19, 2015

Here’s the real reason why US Federal Reserve did not raise interest rates

The Federal Open Market Committee (FOMC) of the Federal Reserve of the United States, the American central bank, has decided to stay put and not raise the federal funds rate for the time being, as it has for a very long time now.

The federal funds rate is the interest rate at which one bank lends funds maintained at the Federal Reserve to another bank on an overnight basis. It acts as a sort of a benchmark for the interest rates that banks charge on their short and medium term loans.

The market was split down the middle on what they expected the Federal Reserve to do. The Federal Reserve has maintained the federal funds rate in the range of zero to 0.25% in the aftermath of the financial crisis which started in September 2008. This has been done in the hope of supporting an American economic recovery.

One view was that the Federal Reserve should start raising the federal funds rate now and get done with it. The other view was that the American economy is still in a fragile state and hence, the federal funds rate should not be raised. Also, any increase in the federal funds rate would have a bad impact on financial and asset markets all over the world, this school of thought held. And that couldn’t possibly be good for the American economy.

The FOMC led by the Federal Reserve Chairperson Janet Yellen chose to go with the latter view.  There are several reasons for the same.
The unemployment rate in the United States fell to 5.1% of the civilian labour force in August 2015. Nonetheless, this number does not take into account those who are working part-time even though they want to work full time. It also does not take into account those who want to work but haven’t actively searched for a job recently.

In fact, the number to look at is the labour force participation ratio. The World Bank defines this as: “the proportion of the population ages 15 and older that is economically active: all people who supply labour for the production of goods and services during a specified period.”

The number had stood at 66% in January 2008 before the start of the financial crisis. As of August 2015 it stands at 62.6%. In August 2014 the number was at 62.9%. Hence, the labour force participation ratio has fallen over the last one year, despite the unemployment rate going down. This means that people have been dropping out of the workforce as they get discouraged at not finding a job and then stop looking for it.

Further, the Federal Reserve has been aiming for an inflation of 2%. As yesterday’s FOMC statement said: “the Committee expects inflation to rise gradually toward 2 percent over the medium term.”

The measure of inflation that the Federal Reserve likes to look at is the core personal consumption expenditure (PCE) deflator. The core PCE deflator is at 1.24%, which is nowhere near 2% that the Federal Reserve is aiming for. A stronger dollar which has made imports into America cheaper as well as lower oil prices are the major reasons for the same.

Interestingly, the FOMC in its statement yesterday said: “Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.” This is the first time this line has made it into the FOMC statement.

What does it mean by this? As Yellen said in a press conference that followed the release of the FOMC statement: “The outlook abroad appears to have become more uncertain of late. And…heightened concerns about growth in China and other emerging market economies have led to volatility in financial markets.”

In the press conference that nobody asked Yellen about what did she really mean by this. Chinese economic growth has been slowing down. Many analysts have argued that China is not growing at the 7% growth rate that it claims to be.

In this scenario it is likely that China might devalue the yuan against the dollar further in order to push up its exports. If China devalues the yuan, Chinese exports will become more competitive as Chinese exporters are likely to cut prices. In this scenario the value of imports coming into the United States will fall further, as exporters from other countries will also have to cut prices in order to compete with the Chinese. This will mean inflation falling further. In my opinion, this is what Yellen and the FOMC really meant.

In the press conference Yellen said that she expects that the FOMC will raise the federal funds rate before the end of this year. The direction in which the Chinese economic growth will unravel is unlikely to become clear so soon.

What this means is that the era of easy money unleashed by the Federal Reserve in late 2008, is likely to continue in the months to come. The Federal Reserve is unlikely to raise the federal funds rate this year. Not surprisingly the stock market in India is having a good day, with the BSE Sensex having rallied by more 470 points or 1.8%, as I write this.

Also, now that the FOMC hasn’t raised interest rates, calls for the RBI governor Raghuram Rajan to cut the repo rate are going to get louder.

The column originally appeared on Firstpost on Sep 18, 2015

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

IMF’s love for printing more money is like treating the wrong ailment

3D chrome Dollar symbolChristine Lagarde, Managing Director of the International Monetary Fund (IMF), issued a statement at the end of the recent G20 meeting in Ankara in Turkey. G20 is essentially an organisation of the governments along with their central banks of the twenty major economies (19 countries plus the European Union) of the world. The finance ministers and the central bank governors of these countries along with those of the European Union, meet regularly “to discuss ways to strengthen the global economy,” among other things.

At the end of the summit in Ankara, Lagarde of IMF said: “The G20 meeting took place at a time of renewed uncertainty for the global economy…The major challenge facing the global economy is that growth remains moderate and uneven. For the advanced economies, activity is projected to pick up only modestly this year and next…A concerted policy effort is needed to address these challenges, including continued accommodative monetary policy in advanced economies.”

What Lagarde meant in simple English is that global economic growth continues to remain slow. And given that central banks of Western economies need to continue doing what they have been since late September 2008—i.e. print money and maintain low interest rates. The term “accommodative monetary policy” is essentially a euphemism for printing money to maintain low interest rates. The hope is that people will borrow and spend more at low interest rates, and economic growth will return.

But that really hasn’t happened. A significant portion of this printed money has found its way into financial markets around the world, leading to bubbles. Now Lagarde wants central banks to carry out more of the same.

Nevertheless, the fundamental problem with the developed countries still remains. As Raghuram Rajan and Luigi Zingales write a new after­word to Saving Capitalism from the Capitalists: “For decades before the financial crisis in 2008, advanced econo­mies were losing their ability to grow by making useful things.”

Further, as Thomas Piketty points out in Capital in the Twenty First Century, between 1900 and 1980, 70–80 percent of the glo­bal production of goods happened in the United States and Europe. By 2010, this share had declined to around 50 percent, around the same level it was at in 1860. This has led to loss of jobs and a slow economic growth through much of the Western world.

This phenomenon which played out over a period of time. The Western governments and central banks tackled this by following an easy money policy, where they kept interest rates low and made borrowing easier for citizens. As Rajan and Zingales write: “They needed to somehow replace the jobs that had been lost to technology and foreign competition… So in an effort to pump up growth, governments spent more than they could afford and promoted easy credit to get households to do the same. The growth that these countries engineered, with its dependence on borrow­ing, proved unsustainable.”

All this easy money ended up causing the financial crisis which started in September 2008. And now Lagarde wants the Western world to do more of the same. The Western world is likely to follow this, given that there is a great belief in central banks being able to engineer growth.

The trouble is that the basic issue discussed earlier, which is at the heart of low economic growth through much of the developed world is something that central banks cannot do anything about. Further, printing money in order to maintain low interest rates, in the hope of people borrowing and spending, can never lead to sustainable economic growth.

As James Rickards writes in The Big Drop—How to Grow Your Wealth During the Current Collapse: “Investors and the Fed [the Federal Reserve, the American central bank] have been expecting another strong expansion since 2009, but it’s not materialized. Growth today isn’t strong because the problem in the economy is not monetary, it is structural.”

This means economic growth cannot be created simply by maintain low interest rates.

Along with the Federal Reserve, other central banks through much of the developed world also believe that they will be able to engineer economic growth. But things have changed at the ground level. The sooner, the IMF and the Western central banks understand this, the better it is going to be for all of us.

The column originally appeared on Firstpost on Sep 7, 2015

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)