Vivek Kaul
The American government is staring at a big problem ahead. Come October 17, and it will hit the debt ceiling set by the American Congress. If this happens it will have global implications. Given that, it is important to understand what the debt ceiling really means and how it can impact the whole world.
So what is the debt ceiling?
The American government, like almost every government in the world, spends more than what it earns. The difference between what it spends and what it earns is met through borrowing money. There is an overall limit to the amount the American government can borrow. This limit is currently set at $16.69 trillion.
So what will actually happen on October 17?
The American Treasury Secretary Jack Lew (equivalent of the finance minister in India) has said that on October 17, the Treasury department will run out of the extraordinary measures it had put in place to ensure that the government doesn’t cross the debt ceiling of $16.69 trillion. Since May 2013, Lew has taken a number of extraordinary measures, like delaying pension fund payments, to ensure that the government expenditure remains under control and hence, the government does not cross the debt ceiling.
So the American government will run out of money on October 17?
The answer to this question is not very clear. Lew has said that as on October 17, the government “
“will be left to meet our country’s commitments at that time with only approximately $30bn.” And this amount will not be enough to meet expenditures of the government, which on certain days can be as high as $60 billion. He has not clarified the exact expected expenditure of the American government as on October 17. Hence, we don’t know if the American government will run out of money on October 17.
So when will the American government actually run out of money?
There are various estimates going around on this. Most analysts agree that the government won’t run out of money on October 18, and will keep chugging along for a brief while. The Bipartisan Policy Center expects this date to be anywhere between October 22 and November 1. As it points out “Updated data on Treasury cash flows through the first week of October show that the range for the Bipartisan Policy Center’s (BPC) X Date – the date on which the United States will be unable to meet all of its financial obligations in full and on time – has narrowed to between October 22 and November 1.”
Economists at JP Morgan have come up with a more precise date of October 24th. As an article on Time.com points out “They (i.e. the economists at JP Morgan) write that it is “extremely unlikely” the Treasury will be able to make it’s payments more than a few days after the 24th, and that the Treasury would most certainly have to default on some payments by November 1st, when large outlays for Social Security, Medicare, retirement benefits for military and civil services workers, and interest payments are due.”
So what will be the impact of this?
The expenditure of the American government will be greater than its income. Until now it has been able to borrow money to finance the gap. It won’t be able to borrow anymore. Given that, it will have to cut down on its expenditure.
AsEric Posner writes on Slate.com “If the debt ceiling is not raised, and the executive branch stops borrowing, the government will need to cut spending by about 15 to 20 percent—or almost 40 percent of spending on everything (yes, Medicare and defense) other than the interest on the debt.”
The impact of the cut in expenditure will be immediate. As Henry J Aaron writes in The New York Times “A decision to cut spending enough to avoid borrowing would instantaneously slash outlays by approximately $600 billion a year. Cutting payments to veterans, Social Security benefits and interest on the national debt by half would just about do the job. But such cuts would not only illegally betray promises to veterans, the elderly and disabled and bondholders.”
Other than having economic consequences, this cut in expenditure will also have social consequences. As Mark Blyth writes in Austerity – The History of a Dangerous Idea in a slightly different context but still applicabl in this case, “Seventy-two percent of the working population(in America) live paycheck to paycheck, have few if any savings, and would have trouble raising $2000 at short notice. There are, as far as we can tell, about 70 million handguns in the United States. So what would happen if…no paychecks were being paid out?”
Hence, cutting expenditure can have dramatic social and economic consequences.
So why is the American government doing nothing about this?
As must be clear by now the consequences of the American government hitting the debt ceiling and not being able to meet its expenditure, will be disastrous. Given this, why hasn’t the government done something about it? Why haven’t they increased the debt ceiling?
The answer lies in the fact that the two houses of the American Congress are currently in a logjam. The House of Representatives is dominated by the Republican Party and the Senate is dominated by the Democratic Party. And both the parties are refusing to talk to each other. The Republicans believe that fiscal profligacy of the American government has gone on for too long and needs to be reined in.
In fact, many Republican Congressmen are not concerned about the debt ceiling at all. As Senator Richard Burr recently said “I’m not as concerned as the president is on the debt ceiling, because the only people buying our bonds right now is the Federal Reserve. So it’s like scaring ourselves.”
So are Republicans right on only the Federal Reserve buying government bonds?
This statement has been true in the recent past. The Federal Reserve of United States, the American central bank has been printing money to buy American government bonds. This helps the government finance its fiscal deficit. Fiscal deficit is the difference between between what a government earns and what it spends.
But Burr’s statement does not take into account the fact that foreign countries hold nearly $5.6 trillion of American government bonds. In comparison, the treasury holds bonds worth $1.93 trillion. These bonds were issued by the American government to borrow money to finance its fiscal deficit.
Interest on these bonds needs to be paid. Also, maturing bonds needs to be repaid. The American government has reached a stage, where it pays the interest on bonds as well as repays maturing bonds, by raising money by selling new bonds and taking on more debt. Any decision to stop paying interest on bonds or default on maturing bonds, will lead to a global financial crisis. As Posner writes “ If he(i.e Obama) stops interest payments, the United States will default. This will not only raise interest payments—costing taxpayers hundreds of billions of dollars—but could spark a financial panic like the meltdown of 2008.”
The US government bonds are the ultimate risk free asset. If the government defaults on interest payments and/or principal repayment, then investors all over the world are going to exit all kinds of financial markets. No wonder China which holds more than a trillion dollars of American government bonds is worried. The Chinese Vice Finance Minister Zhu Guangyao recently said “We naturally are paying attention to financial deadlock in the U.S. and reasonably demand that the U.S. guarantee the safety of Chinese investment there.”
So that brings us back to the question why aren’t Republicans and Democrats talking?
This basically boils down to the fact that Republican Congressmen seem to be confident that the government is in a position to work its way around the debt ceiling. As Senator Orrin Hatch recently said “I think the administration could work on who gets paid and who doesn’t in a way that would pull us through.”
It is easy to ask the government to prioritize payments, but anything done around those lines could have serious legal implications. It needs to be pointed out that there are no legal provisions to decide which expenditure should be cut first. “There is no clear legal basis for deciding what programs to cut. Defense contractors, or Medicare payments to doctors? Education grants, or the F.B.I.? Endless litigation would follow. No matter how the cuts might be distributed, they would, if sustained for more than a very brief period, kill the economic recovery and cause unemployment to return quickly to double digits,” Aaron points out in The New York Times.
The politicians on both the sides are also taking it easy because the markets haven’t reacted to this lack of communication between the two political parties on the debt ceiling. As Senator Hatch put it “I don’t think the markets have been spooked so far, and I personally believe that if they realized there was a legitimate attempt to make the government work, they would be less likely [to be spooked].”
So why haven’t the markets reacted?
The debt ceiling has been in place since 1939. And since then the American Congress has raised it numerous times to allow the government to borrow more. As an article in the Christian Science Monitor points out “An overall cap on federal debt has been in place since 1939, and Congress has raised it numerous times since then. The Treasury Department counts 78 times since 1960.”
What has happened 78 times is also likely to happen one more time.
This explains why the various financial markets in America and around the world continue to remain stable and are not taking into account the possibility of another crisis. As Bill Gross manager of the world’s biggest bond fund, told Bloomberg Television “The odds of a default are “a million-to-one” as the Treasury Department will be able to take other measures to ensure it is servicing the country’s debt.”
Hence, the market is currently expecting the Republicans and the Democrats to sit down and solve the problem before October 17.
So will the markets continue to remain stable?
That’s a tricky question to answer. The closer we get to October 17 without any solution in sight, the more the stability of the markets will be threatened. In fact, if the American stock market falls it might even get the Republicans and the Democrats to start talking. As John Cassidy of The New Yorker magazines writes on his blog “If the market fell by, say, three or four hundred points for three days in a row, and then lurched down another eight hundred points, or even a thousand points, the effect would be salutary. How can I say that? Tens of millions of Americans would grow alarmed about their 401k plans. On Wall Street, there would be margin calls, liquidity runs, and other disturbing developments that inevitably accompany market breaks. Rumors would start to spread about the health of various financial institutions. You don’t have to subscribe to a tail-wags-the-dog view of finance and politics to believe that this would lead to a rapid change of thinking, and of behaviour, in Washington.”
This will get the two sides talking on the debt ceiling for sure.
The article originally appeared on www.firstpost.com on October 9, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)
Ponzi
Once more! Fed is blowing bubbles to cover up growing inequality
Vivek Kaul
The Western central banks(primarily the Federal Reserve of United States and the Bank of England) have been printing money (or quantitative easing as they like to call it) at a very rapid rate since the start of the financial crisis in late 2008. The idea is to print and pump money into the financial system and thus ensure that there is a lot of money going around, leading to low interest rates.
At low interest rates people were expected to borrow and spend more. When they did that businesses would benefit and the economic growth would improve. But this theory hasn’t really worked as well as it was expected to.
The money that was and continues to be printee, has found its way into various financial markets around the world, leading to bubbles and at the same time benefiting those it wasn’t intended to. As Albert Grice of Societe Generale writes in a report titled Is the Fed blowing bubbles to cover up growing inequality…again? dated September 27, 2013 “Quantitative Easing(QE) has mainly helped the rich. The Bank of England admitted as much a year ago. Specifically it said that its QE programme had boosted the value of stocks and bonds by 25%, or about $970 billion. It then calculated that about 40 percent of those gains went to the richest 5 percent of British households.”
The situation is similar in the United States as well where the Federal Reserve prints $85 billion every month to keep interest rates low. As Gary Dorsch Editor, Global Money Trends newsletter, writes in his later newsletter dated October 3, 2013, “The Fed has always kept its foot pressed firmly on the monetary accelerator, and thus, keeping the speculative juices flowing. Over the past 1-½ years, the Fed has increased the…money supply by +10% to an all-time high of $12-trillion. In turn, traders have bid-up the combined value of NYSE and Nasdaq listed stocks to a record $22-trillion. That’s great news for the Richest-10% of Americans that own 80% of the shares on the stock exchanges.”
Hence, it is safe to say that bubbles across various financial markets have helped the rich get richer, which wasn’t the idea in the first place. Numbers confirm this story. As Emmanuel Saez, of University of California at Berkeley, points out in a note titled Striking it Richer: The Evolution of Top Incomes in the United States and dated September 3, 2013 “From 2009 to 2012, average real income per family grew modestly by 6.0%…However, the gains were very uneven. Top 1% incomes grew by 31.4% while bottom 99% incomes grew only by 0.4% from 2009 to 2012. Hence, the top 1% captured 95% of the income gains in the first three years.”
This rise in income inequality might be one reason why the Federal Reserve of United States continues to print money. As Edwards writes “while governments preside over economic policies that make the very rich even richer…the middle classes also need to be thrown a sop to disguise the fact they are not benefiting at all from economic growth.”
So how is the middle class offered a sop in disguise? This is done through an easy money policy of maintaining low interest rates by printing money. In the process, the home prices continue to go up and this ensures that the home owning middle class(which forms a significant portion of both the American and the British population) feels richer.
The S&P/Case-Shiller 20 City Home Index which measures the value of residential real estate in 20 metropolitan areas of the U.S., shows precisely that. Overall home price rose by 12.4% in July 2013, in comparison to July 2012. Home prices were up by 27.5% in Las Vegas. They were up 24.8%, 20.8% and 20.4%, in San Francisco, Los Angeles and San Diego, respectively.
A similar scenario seems to be playing out in Great Britain as well. As Edwards wrote in a report titled Fools dated September 19, 2013 “Evidence is mounting that easy money …in the UK housing market is leading to another explosion of prices, with London, as always, leading the way with double-digit house price inflation.”
Edwards further points out in another report titled If UK Chancellor George Osborne is a moron, Fitch’s Charlene Chu is a heroine dated June 4, 2013, that people have been unable to buy homes despite interest rates being at very low levels because the prices continue to remain very high. As he wrote “Young people today haven’t got a chance of buying a house at a reasonable price, even with rock bottom interest rates. The Nationwide Building Society data shows that the average first time buyer in London is paying over 50% of their take home pay in mortgage payments – and that is when interest rates are close to zero!”
Of course people who already own homes and form a major portion of the population are feeling richer. And thus income inequality is being addressed.
This mistake of propping up housing prices to make the middle class feel rich was one of the major reasons for the real estate bubble in the United States, which burst, before the start of the current financial crisis.
The top 1% of the households accounted for only 7.9% of total American wealth in 1976. This grew to 23.5% of the income by 2007. This was because the incomes of those in the top echelons was growing at a much faster rate.
The rate of growth of income for the period for those in the top 1% was at 4.4% per year. The remaining 99% grew at 0.6% per year. What is even more interesting is the fact that the difference was even more pronounced since the 1990s.
Between 1993 and 2000, the income of the top 1% grew at the rate of 10.3% per year, and the income of the remaining 99% grew at 2.7% per year. Between 2002 and 2007, the income for the top 1% grew at the rate of 10.1% per year. For the remaining it grew at a minuscule 1.3% per year. In fact the wealthiest 0.1% of the population accounted for 2.6% of American wealth in 1976. This had gone up to 12.3% in 2007.
But it was not only the super rich who were getting richer. Even those below them were doing quite well for themselves. In 1976, the top 10% of households earned around 33% of the national income, by 2007 this had reached 50% of the national income.
American politicians addressed this inequality in their own way by making sure that money was available at low interest rates. As Raghuram Rajan writes in Fault Lines: How Hidden Fractures Still Threaten the World Economy “Politicians have therefore looked for other ways to improve the lives of their voters. Since the early 1980s, the most seductive answer has been easier credit. In some ways, it is the path of least resistance…Politicians love to have banks expand housing credit, for all credit achieves many goals at the same time. It pushes up house prices, making households feel wealthier, and allows them to finance more consumption. It creates more profits and jobs in the financial sector as well as in real estate brokerage and housing construction. And everything is safe – as safe as houses – at least for a while.”
Of course this is really not a solution to the problem of addressing inequality. It only makes people feel richer for a short period of time till the home prices keep rising and the bubble becomes bigger. But eventually the bubble bursts.
The irony is that people refuse to learn from their mistakes. The same mistake of propping up home prices is being made all over again.
The article originally appeared on www.firstpost.com on October 3, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)
“ India should have been after Pakistan to start talking after 26/11”
Vivek Kaul
Stuart Diamond has taught and advised on negotiation and cultural diversity to corporate and government leaders in more than 40 countries. For more than 90% of the semesters over the past 15 years his negotiation course has been the most popular at the Wharton Business School, based on the course auction. He is also the author of Getting More – How You Can Negotiate to Succeed in Work and Life. In this interview he speaks to Firstpost on why India and Pakistan need to negotiate, how the soldiers negotiate with tribal leaders in Afghanistan and why the lack of people skills is proving costly for technology firms.
What is the most important point in any negotiation?
Almost any negotiation worth doing with anybody, whether its a billion dollar deal, diplomacy or my kid wants an ice cream cone, is a high stakes negotiation to that person. So almost every negotiation that is done in the world begins as an emotional negotiation. When stakes are high people get emotional and listen less.
That’s a very perceptive point you make….
Hence, unless you deal with that in the beginning you are not going to get the response you like. Also, I’d like to point out that we have begun to study the cost of conflict i.e. the cost of not collaborating. It turns out that India is in a fair amount of trouble when it comes to this. Only 20% of the people in India, trust each other, 80% don’t. If India had the same amount of trust as Sweden, its GDP would be $95 billion higher, which is twice as much as the defence budget, ten times the education budget, fourteen times the health budget and equal to the entire budget shortfall. In addition to that it would have 38 million more jobs, which is twice the population of Mumbai. Therefore the lack of trust in this country is a significant social and economic issue.
Why would that be? Isn’t trust also a function the amount of equality in the country? Like you gave the example of Sweden. Sweden has one of the highest equality levels in the world…
I would phrase it differently. I would say that trust occurs when someone thinks you want to do something for them, even if you are unequal. It begins with the notion of do I care about them? For example, when we had terrorist attacks in Mumbai around five years back, that’s when India and Pakistan should have started talking non stop. That’s part and parcel of the problem, which is even if Pakistan wanted to stop talking, India should have been after Pakistan to start talking, because you cannot solve a problem by not talking. In other words, if we mistrust each other, that’s the time to start talking. So this is counter-intuitive to many people because it says that the less I trust you the more I need to talk to you.
Can you elaborate on that?
For example, instead of India threatening to clean out terrorist cells in Pakistan, and instead of Pakistan putting people on the border, India should say to Pakistan, do you like terrorism? If you don’t like terrorism, we don’t. You want us to be able to do something about it? Let’s start small. What’s the worse problem we can solve in the easiest way? How do we start? Have a discussion about it. As opposed to do it my way. Or I demand this. There needs to be discussion. Even my 11 year old son, when he breaks something on the floor, I don’t blame the floor, I say Alexander how can you prevent this from happening again? Even a 11 year old kid understands that. How do we fix the process?
Not many people would buy that argument these days…
So much time is being spent arguing over yesterday instead of fixing the process for tomorrow. Yesterday adds no value. It is done and you can’t fix it and you can’t do anything about it. Tomorrow is what we can add value to. Too many people are backward facing when they should be forward facing.
One of the interesting examples that I came across was where you allowed your son to watch Scooby Doo for every minute that he played the piano. What was that all about?
It was a trade. First of all life is about a trade. Even a relationship. Quid pro quo. If you don’t need each others needs, soon you won’t have a relationship. And parents expect kids to do things for nothing, when they themselves would never do things for nothing. I wanted to teach my child the value of the trade. I paid money for the piano. I knew he would grow out of Scooby Doo, but he still plays the piano.
What is the lesson?
I wanted to know what do we trade. It teaches people to be responsible. That’s a really good thing to be thinking about with kids and others. What do they value? It doesn’t have to be monetary. It can be something intangible. It can be a letter of reference.
Letter of reference?
Let me tell you an interesting story. About three months ago one of Google’s senior negotiators went to do a deal in the Southern United States where they doubled the fibre optics capacity. The first tranche cost $6 million and it closed two years ago. The vendor wanted $6 million for the second tranche. Instead of asking for a discount this Google negotiator said what can Google do for you? And the vendor said you can write us a letter of reference, so we could build our business.
That’s interesting…
The Google negotiator said fine we will do that. And then he said, what can you do for Google? The vendor decided to offer a discount to Google. And the vendor charged Google $6000 for an installation of $6 million, a 99.9% discount. This happened because they made the human connection and it wasn’t just about the money.
Can you give us another example of where an intangible played an important part in a negotiation?
My models are not only used by Google but by Special Operations in Afghanistan. If they make a connection with the tribal leaders, which may be something as simple as praising the fact that he(i.e. the tribal leader) was a war hero against the Soviets, the tribal leader will tell them where the bombs are buried and where the Taliban are. People say negotiations are complicated. No they are that simple. I like to watch kids negotiate. Kids are very simple. I am happy. I am sad. I am hungry. We are not getting along. A lot of what passes for negotiation is too complicated. Its just a conversation about what’s going on. The thing is it is not rocket science. But unless you know how to do it, it’s completely invisible. These tools are obvious when you see them, but are invisible unless you know them.
The Afghanistan example was interesting..
Let me give you another example. In Afghanistan, you have got tribal leaders interested in co-operating with the Allies. So, I teach the soldiers to say, think your kid is going to be sick next year? It takes some months to get medicines in Afghanistan. Your kid might die. We can get the medicine the same day. Who cares about that in your village? Whether they are a hard bargainer or a soft bargainer, it will be very hard for them(i.e. the tribal leaders) to turn down the alliance. So the more you can create a vision for someone, the more they are likely to buy in.
Any other example?
Here is one. Google wanted to put cigarette advertising and liquor advertising on cell phones. The legal department of Google did not want to do this because there was danger of kids getting access to it. We realised that whenever people think this is risky if you are more incremental you can be more persuasive. So then what was proposed was a limited experiment. We try with cigarette advertising in Britain and liquor advertising in the US for a small portion of the market and see if it can protected from under age people. Google would use that as a test to see how people self regulate. Google would be a leader in the industry as opposed to someone trying to get a heads up. So you can completely turn something around by being more incremental and by re-framing it in a way to capture the imagination of people.
In complicated situations do outsiders tend to be the best negotiators?
In fact, somebody without an emotional history is often the right negotiator. There are times when you can do it yourself but by the time it gets to a situation where the husband and wife are fighting with each other, you need a marriage counsellor. Before that point you can often do it yourself. But it is also true that sometimes the best negotiator with my wife is my son. So the right negotiator is the person who can make the best connection with the other side. The right negotiator is not the smartest, the most skilled and the most experienced. It might be the weakest member of your team.
That’s interesting. Can you give us an example?
I told this to the senior management of Morgan Stanley last month and they said that this flies in the face of a 100 years of investment banking experience. They are going to think of changing this. For 100 years, the most senior person did the negotiation. And that’s not often the right negotiator.
Because he has got too many things to do anyway. You need someone who does not come with a baggage…
Yes. Exactly.
“Men better do better at negotiations than women” you point out. Why is that?
And that’s only because men practice more. Women are instinctively better negotiators than men. They listen more. But they don’t practice enough and so they are not trained enough. And some training is better than no training. As soon as they get trained at negotiations they do very very well. In fact, 30% of the people in my classes are women and they get more than half the highest marks.
One of the things that you write about is that the lack of people skills is proving costly to technology firms…
Absolutely. I gave a talk four years ago to 400 people from Microsoft from the business development and legal departments. I started the talk by saying that this morning I googled Microsoft. I typed “Europe hates Microsoft”. Why did I get 10 million hits in a tenth of a second? I said you are thinking it costs you money because people don’t like you. People investigate you because they don’t like you. The notion is that it is not just about the technology, if people don’t like you they will find a way not to buy your products and services.
Hmmm. And that’s impacting technology firms?
The FBI in Washington tells me that they use Oracle. They hate Larry Ellison and they are trying to find a way to use something else. And of course if you have got $12 billion like Larry Ellison has, you can be an SOB, but the problem is when you get to an America’s Cup race, only two people show up, including you. So there are costs to that even if you can get away with it for a short period of time.
True…
Around 25 years ago I read a really an interesting quote from a treatise called The Myth of US Industrial Supremacy. though I am not sure of it.“There is no human organisation, institution or civilization, that cannot given enough time be ruined”. So I worry about it. However, powerful I am, if I make myself the issue over and over again, people are going to run away. The lack of people skills is the Achilles’ heal for the technology industry because it is not just about the technology. It is about how people feel about the technology.
The interview originally appeared on www.firstpost.com on October 1, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)
Try Again. Fail again. Fail better – Disaster formula of US Federal Reserve
Vivek Kaul
“Now we know better. If we learn from experience, history need not repeat itself,” wrote economists George Akerlof and Paul Romer, in a research paper titled Looting: The Economic Underworld of Bankruptcy for Profit.
But that doesn’t seem to be the case with the Federal Reserve of United States, which seems to be making the same mistakes that led to the financial crisis in the first place. Take its decision to continue printing money, in order to revive the American economy.
In a press conference to explain the logic behind the decision, Ben Bernanke, the Chairman of the Federal Reserve of United States, said “we should be very reluctant to raise rates if inflation remains persistently below target, and that’s one of the reasons that I think we can be very patient in raising the federal funds rate since we have not seen any inflation pressure.”
The Federal Reserve of United States prints $85 billion every month. It puts this money into the financial system by buying bonds. With all this money going around interest rates continue to remain low. And at low interest rates the hope is that people will borrow and spend more money.
As people spend more money, a greater amount of money will chase the same number of goods, and this will lead to inflation. Once a reasonable amount of inflation or expectations of inflation set in, people will start altering their spending plans. They will buy things sooner rather than later, given that with inflation things will become more expensive in the days to come. This will help businesses and thus revive economic growth.
The Federal Reserve has an inflation target of 2%. Inflation remains well below this level. As Michael S. Derby writes in the Wall Street Journal “As of the most recent reading in July, the Fed’s favoured inflation gauge, the personal consumption expenditures price index, was up 1.4% from a year ago.”
So, given that inflation is lower than the Fed target, interest rates need to continue to be low, and hence, money printing needs to continue. That is what Bernanke was basically saying.
Inflation targeting has been a favourite policy of central banks all over the world. This strategy essentially involves a central bank estimating and projecting an inflation target and then using interest rates and other monetary tools to steer the economy towards the projected inflation target. The trouble here is that inflation-targeting by the Federal Reserve and other central banks around the world had led to the real estate bubble a few years back. The current financial crisis is the end result of that bubble.
Stephen D King, Group Chief Economist of HSBC makes this point When the Money Runs Out. As he writes “the pursuit of inflation-targetting…may have contributed to the West’s financial downfall.”
King writes about the United Kingdom to make his point. “Take, for example, inflation targeting in the UK. In the early years of the new millennium, inflation had a tendency to drop too low, thanks to the deflationary effects on manufactured goods prices of low-cost producers in China and elsewhere in the emerging world. To keep inflation close to target, the Bank of England loosened monetary policy with the intention of delivering higher ‘domestically generated’ inflation. In other words, credit conditions domestically became excessive loose…The inflation target was hit only by allowing domestic imbalances to arise: too much consumption, too much consumer indebtedness, too much leverage within the financial system and too little policy-making wisdom.”
What this means is that the Bank of England(as well as other central banks like the Federal Reserve) kept interest rates too low for too long because inflation was at very low levels. Low interest rates did not lead to inflation, with people borrowing and spending more, primarily because of low cost producers in China and other parts of the emerging world.
Niall Ferguson makes this point in The Ascent of Money – A Financial History of the World in the context of the United States. As he writes “Chinese imports kept down US inflation. Chinese savings kept down US interest rates. Chinese labour kept down US wage costs. As a result, it was remarkably cheap to borrow money and remarkably profitable to run a corporation.”
The same stood true for the United Kingdom and large parts of the Western World. With interest rates being low banks were falling over one another to lend money to anyone who was willing to borrow. And this gradually led to a fall in lending standards.
People who did not have the ability to repay were also being given loans. As King writes “With the UK financial system now awash with liquidity, lending increased rapidly both within the financial system and to other parts of the economy that, frankly, didn’t need any refreshing. In particular, the property sector boomed thanks to an abundance of credit and a gradual reduction in lending standards.” What followed was a big bubble, which finally burst and its aftermath is still being felt more than five years later.
As newsletter write Gary Dorsch writes in a recent column “Asset bubbles often arise when consumer prices are low, which is a problem for central banks who solely target inflation and thereby overlook the risks of bubbles, while appearing to be doing a good job.”
A lot of the money printed by the Federal Reserve over the last few years has landed up in all parts of the world, from the stock markets in the United States to the property market in Africa, and driven prices to very high levels. At low interest rates it has been easy for speculators to borrow and invest money, wherever they think they can make some returns.
Given this argument, it was believed that the Federal Reserve will go slow on money printing in the time to come and hence, allow interest rates to rise (This writer had also argued something along similar lines). But, alas, that doesn’t seem to be the case.
As Claudio Borio and Philip Lowe wrote in the BIS working paper titled Asset prices, financial and monetary stability: exploring the nexus (the same paper that Dorsch talks about) “lowering rates or providing ample liquidity when problems materialise but not raising rates as imbalances build up, can be rather insidious in the longer run.”
Once these new round of bubbles start to burst, there will be more economic pain. The Irish author Samuel Beckett explained this tendency to not learn from one’s mistakes beautifully. As he wrote “Ever tried. Ever failed. No matter. Try Again. Fail again. Fail better.”
The Federal Reserve seems to be working along those lines.
The article originally appeared on www.firstpost.com on September 20, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)
Why Federal Reserve ‘really’ wants to go slow on money printing
Vivek Kaul
Over the last few months, there has been talk about the Federal Reserve of United States, the American central bank, wanting to slowdown its money printing and gradually doing away with it altogether.
Every month the Federal Reserve prints $85 billion and puts that money into the American financial system, by buying bonds of different kinds. The idea is that with enough money floating around in the financial system, the interest rates will continue to remain low.
At lower interest rates people are more likely to borrow and spend more. And this in turn will help economic growth, which has been faltering, in the aftermath of the financial crisis, which started in late 2008.
Some economic growth has returned lately. Recently the GDP growth for the period of three months ending June 30, 2013, was revised to 2.5% from the earlier 1.7%. But even an economic growth of 2.5% is not enough, primarily because the country needs to make up for the slow economic growth that it has experienced over the past few years.
The fear is that with all the money floating around in the financial system, too much money will start chasing too few goods, and finally lead to high inflation. But that hasn’t happened primarily because even at low interest rates, borrowing has been slow. Hence, what economists call the velocity of money (or how fast money changes hands) has been low. Given this, inflation has been low. Consumer price inflation in the United States, for the period of twelve months ending June 2013, stood at 1.3%.
The rate of inflation is well below the inflation target of 2% that the Federal Reserve is comfortable with. So if inflation isn’t really a concern, and the economic growth is still not good enough, why is the Federal Reserve in a hurry to go slow on printing money?
As Gary Dorsch, the Editor – Global Money Trends newsletter, writes in his latest column “The fragile US-economy might find itself sinking into a full blown recession by the first quarter of 2014. However, the Fed’s determination to start scaling down QE-3 is essentially in reaction to the demands of the Bank of International Settlements (BIS), – the central bank of the world – which says it is time to rethink US-monetary policy. The BIS argues that blowing even bigger bubbles in the US-stock market can do more harm to the US-economy than the old enemy of high inflation. Thus, going forward, the costs of continuing with QE now exceed the benefits.”
Quantitative easing or QE is the technical term that economists have come up with for money printing that is happening across different parts of the western world.
What Dorsch has written needs some detailed examination. The argument for keeping the money printing going has been that it has not led to any serious inflation till now, so let us keep it going. While inflation may not have cropped up in everyday life, it has turned up somewhere else. A lot of the money printed by the Federal Reserve has found its way into financial markets around the world, including the American stock market. And this has led to investment bubbles where prices have gone up way over what the fundamentals justify.
The Federal Reserve, meanwhile, has continued with the money printing because it hasn’t shown up in inflation. Central banks work with a certain inflation target in mind. If the inflation is expected to cross that level, then they start taking steps to ensure that interest rates go up.
At 1.3%, inflation in the United States is well below the Federal Reserve’s target of 2%. Some recent analysis coming out suggests that inflation-targeting might be a risky strategy to pursue. Stephen D King, Group Chief Economist of HSBC makes this point in his new book When the Money Runs Out. As he writes “the pursuit of inflation-targetting…may have contributed to the West’s financial downfall.”
King gives the example of United Kingdom to elaborate on his point. As he writes “Take, for example, inflation targeting in the UK. In the early years of the new millennium, inflation had a tendency to drop too low, thanks to the deflationary effects on manufactured goods prices of low-cost producers in China and elsewhere in the emerging world. To keep inflation close to target, the Bank of England loosened monetary policy with the intention of delivering higher ‘domestically generated’ inflation. In other words, credit conditions domestically became excessive loose…The inflation target was hit only by allowing domestic imbalances to arise: too much consumption, too much consumer indebtedness, too much leverage within the financial system and too little policy-making wisdom.”
Hence, the Bank of England, kept interest rates too low for too long because the inflation was low. With interest rates being low banks were falling over one another to lend money to anyone who was willing to borrow. And this gradually led to a fall in lending standards. People who did not have the ability to repay were also being given loans. As King writes “With the UK financial system now awash with liquidity, lending increased rapidly both within the financial system and to other parts of the economy that, frankly, didn’t need any refreshing. In particular, the property sector boomed thanks to an abundance of credit and a gradual reduction in lending standards.”
So the British central bank managed to create a huge real estate bubble, which finally burst, and the after effects are still being felt. And all this happened while the inflation continued to be at a fairly low level.
But this focus on ‘low inflation’ or ‘monetary stability’ as economists like to call it, turned out to be a very narrow policy objective. As Felix Martin writes in his brilliant book Money- The Unauthorised Biography “The single minded pursuit of low and stable inflation not only drew attention away from the other monetary and financial factors that were to bring the global economy to its knees in 2008 – it exacerbated them…Disconcerting signs of impending disaster in the pre-crisis economy – booming housing prices, a drastic underpricing of liquidity in asset markets, the emergence of shadow banking system, the declines in lending standards, bank capital, and the liquidity ratios – were not given the priority they merited, because, unlike low and stable inflation, they were simply not identified as being relevant.”
The US Federal Reserve wants to avoid making the same mistake that led to the dotcom and the real estate bubble and finally a crash. As Dorsch writes “A BIS working paper that traces booming stock markets over the past 110-years, finds that they nearly always sink under their own weight, – and causing lasting damage to the local economy. Asset bubbles often arise when consumer prices are low, which is a problem for central banks who solely target inflation and thereby overlook the risks of bubbles, while appearing to be doing a good job.”
Over the last 25 years, the US Federal Reserve has been known to cut interest rates at the slightest sign of trouble. But only on rare occasions has it raised interest rates to puncture bubbles. Alan Greenspan let the dotcom bubble run full steam. Then he, along with Ben Bernanke, let the real estate bubble run. By the time the Federal Reserve started to raise interest rates it was a case of too little too late.
A similar thing seems to have happened with the current stock market bubble, where the Federal Reserve has printed and pumped money into the market, and managed to keep interest rates low. But this money instead of being borrowed by American consumers has been borrowed by investors and found its way into the stock market.
As Claudio Borio and Philip Lowe wrote in the BIS working paper titled Asset prices, financial and monetary stability: exploring the nexus (the same paper that Dorsch talks about) “lowering rates or providing ample liquidity when problems materialise but not raising rates as imbalances build up, can be rather insidious in the longer run. They promote a form of moral hazard that can sow the seeds of instability and of costly fluctuations in the real economy.”
Guess, the Federal Reserve is finally learning this obvious lesson.
The article originally appeared on www.firstpost.com on September 6, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)