Albert Edwards

Central bankers are morons: Why bad economic news is treated as good news by stock market

yellen_janet_040512_8x10

Vivek Kaul


When it comes to investing in the stock market, there used to be two kinds of investors: those who invested on the basis of the fundamentals of a stock and and those who invested on the basis of non fundamentals.
Investors like Warren Buffett specialise in investing on the basis of fundamentals. These investors go through balance sheets, annual reports etc., in great detail, trying to figure out how well a company they want to invest in is doing in terms of sales, expenditure and profits.
On the other hand, the non fundamental investor most of the times is trying to do what John Maynard Keynes described best. John Lanchester writes about this “famous description” in his recent book How to Speak Money” “He (i.e. the non fundamental investor) is looking at a photo of six girls and trying to pick, not which girl he thinks is the prettiest, and not which he thinks most people will think is the prettiest, but which most people will think most people will think is the prettiest…In other words the non-fundamentals investor isn’t trying to work out what companies he should invest in, or what company most investors will think they should invest in, but which company most investors will think most investors will want to invest in.”
Or as Keynes put it in his magnum opus The General Theory of Employment, Interest and Money “It is not a case of choosing those [faces] that, to the best of one’s judgement, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.”
And this is how the stock market investors were neatly divided with the majority of them trying to figure out “ what average opinion expected the average opinion to be”. This neat division was broken down in the aftermath of the current financial crisis which started in September 2008. The markets are now ruled by the central banks.
As Ben Hunt wrote in the Epsilon Theory investment letter dated August 5, 2014, and titled Fear and Loathing on the Marketing Trail, 2014 “Today, everyone believes that market price levels are largely driven by monetary policy and that we are all being played by politicians and central bankers using their words for effect rather than direct communication.”
Monetary policy is essentially the process by which a central bank controls the amount of money in the financial system of a country. In the aftermath of the financial crisis, central banks of Western economies started printing money.
Economist John Mauldin in a recent column titled The End of Monetary Policy estimates that central banks have printed $7-8 trillion since the start of the financial crisis. It is worth pointing out here that this money is not actually printed, but created digitally, nonetheless “money being printed” is an easier way to talk about the whole thing.
Once this new money is created it is used to buy bonds, both private as well as government. This has been done to pump money into the financial system and ensure that there is enough money going around to keep interest rates low.
At low interest rates the hope was that people would borrow and spend more. This would create some demand and help economic growth. But that did not happen. What happened instead was that this newly created money found its way into financial markets all over the world.
This broke down the link between economic performance of a country and the performance of its stock market. The stock markets rallied anyway. This point was very well made recently by Claudio Borio, the head of the Bank of International Settlement’s monetary and economic department: “Buoyant financial markets are out of sync with the shaky global economic and geopolitical outlook. Overall, it is hard to avoid the sense of a puzzling disconnect between the markets’ buoyancy and underlying economic developments globally. Financial markets are euphoric, in the grip of an aggressive search for yield, and yet investment in the real economy remains weak while the macro-economic and geopolitical outlook is still highly uncertain.”
This has led to a situation where bad economic news is treated as good news by the stock markets because the investors know that this will lead to central banks printing more money as they try and get economic growth going again. As Gary Dorsch, Editor, Global Money Trends newsletter, wrote in a recent column “Bad economic news is treated as Bullish news for the stock market, because it lead to expectation of more “quantitative easing.” And the easy money flows that are injected by central banks go right past goods and services (ie; the real economy) and are whisked into the financial markets, where it pushes up the prices of stocks and bonds. In simple terms, what matters most to the stock markets are the easy money injections from the central banks, and to a lesser extent, the profits of the companies whose stocks they are buying and selling.”
This single paragraph explains all the stock market rallies that have happened all over the world in the last few years. At the same time the “easy money” created by central banks has also helped boost corporate profits. As Dorsch puts it “The boom in corporate profits has been heavily subsidized by cheap and easy credit, which has allowed big companies to boost returns by paring down interest costs and buying back shares.” And this has also boosted stock market performance. The question is till when can this last? Do investors really believe that central banks will keep coming to their rescue forever? These are not easy questions to answer and on this your guess is as good as mine.
Hunt who writes the Epsilon Theory newsletter believes that “No one requires convincing that market price levels are unsupported by real world economic activity. Everyone believes that this will all end badly, and the only real question is when.”
Albert Edwards of Societe Generale is a little more direct about the issue. As he wrote in recent research note dated October 23, 2014: “The central banks for all their huffing and puffing cannot eliminate the business cycle. And they should have realised after the 2008 Great Recession that the longer they suppress volatility, both economic and market, the greater the subsequent crash. Will these morons ever learn?” He also quotes Guy Debelle, head of the BIS market committee, as saying that “investors had become far too complacent, wrongly believing that central banks can protect them, and many staking bets that are bound to “blow up” at the first sign of stress.”
The Federal Reserve of the United States has gradually been winding down its money printing programme. Currently it prints $15 billion every month. The Federal Open Market Committee is supposed to meet on October 28-29, later this month. The expectation is that the committee will wind up the money printing programme.
The stock market in the US has remained largely flat over the last two months. In case it starts to fall, once the Federal Reserve stops printing money, it is likely that the American central bank will start printing money again. As Christopher Wood wrote in the Greed and Fear investment newsletter in November last year “The key issue is what might trigger a market correction. The market consensus continues to focus on the tightening in financial conditions triggered by “tapering”. Still such a hypothetical correction is not so big a deal to GREED & fear, since any real equity decline caused by tapering is likely to lead, under a Fed run by Janet Yellen, to renewed easing.”
So what is the real threat then? “The real threat to US equities is when the American economy fails to re-accelerate as forecast,” wrote Wood. And that is something worth worrying about.

The article originally appeared on www.FirstBiz.com on Oct 26, 2014

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

 

Why investors behave like football goalkeepers and how that hurts

goalkeeperVivek Kaul  
A very good friend of mine recently decided to take a sabbatical. But two weeks into it he started getting fidgety. The prospect of not doing anything was turning out to be too hot to handle for him. So, one morning he called up his boss and told him that this decision to go on a sabbatical was not the right one, and given this, he wanted to get back to work.
My friend’s boss, had taken a sabbatical last year, and understood the value of a big break away from work. Given this, he refused to let my friend get back to work so soon, and suggested that he continue with the sabbatical, now that he had decided to take one.
One more week into the sabbatical, my friend simply couldn’t handle it. One day he simply landed up at work, without consulting his boss. And thus ended his sabbatical.
The point in sharing this story is that it is difficult “do nothing”, even though at times it might be the most important thing to do.
In a recent interview to Wisden, the former Australian cricketer Dean Jones, pointed out that two thirds of Sachin Tendulkar’s game was based around forward defence, back-foot defence and leaving the ball, without trying to play it. As Amay Hattangadi and Swanand Kelkar write in a research eport titled The Value of Doing Nothing and dated February 2014 “As any coach would vouch, letting the ball go is possibly as important as hitting good shots in the career of a batsman.”
In fact, not doing anything is a very important part of successful investing. But the investment industry is not structured liked that. They have to ensure that their customers keep trading, even if it is detrimental for the them. As Arthur Levitt, a former Chairman of the Securities Exchange Commission, the stock market regulator in the United States, writes in Take on the Street – How to Fight for Your Financial Future “Brokers may seem like clever financial experts, but they are first and foremost salespeople. Many brokers are paid a commission, or a service fee, on every transaction in accounts they manage. They want you to buy stocks you don’t own and sell the ones you do., because that’s how they make money for themselves and their firms. They earn commissions even when you lose money.”
The brokers only make money when investors keep buying and selling through them. This is also true about insurance and mutual fund agents, who make bigger commissions at the time investors invest and then lower commissions as the investors stay invested.
As Adam Smith (not the famous economist) writes in The Money Game “They could put you in some stock that would go up ten times, but then they would starve to death. They only get commissions when you buy and sell. So they keep you moving.”
Levitt proves this point by taking the example of Warren Buffett to make his point. “Warren Buffett, the chairman and CEO of Berkshire Hathaway Inc and one of the smartest investors I’ve ever met, knows all about broker conflicts. He likes to point that any broker who recommended buying and holding Berkshire Hathaway stock from 1965 to now would have made his clients fabulously wealthy. A single share of Berkshire Hathaway purchased for $12 in 1965 would be worth $71,000 as of April 2002. But, any broker who did that would have starved to death.”
Hence, it is important for stock brokers, insurance and mutual fund agents to get their investors to keep moving from one investment to another.
But how do stock brokers manage to do this all the time? Andy Kessler has an excellent explanation for this in Wall Street Meat. As he writes “The market opens for trading five days a week… Companies report earnings once every quarter. But stocks trade about 250 days a year. Something has to make them move up or down the other 246 days [250 days – the four days on which companies declare quarterly results]. Analysts fill that role. They recommend stocks, change recommendations, change earnings estimates, pound the table—whatever it takes for a sales force to go out with a story so someone will trade with the firm and generate commissions.”
But why are these analysts taken seriously more often than not? As John Kenneth Galbraith writes in The Economics of Innocent Fraud “ And there is no easy denial of an expert’s foresight. Past accidental success and an ample display of charts, equations and self-confidence depth of perception. Thus the fraud. Correction awaits.”
This has led to a situation where investors are buying and selling all the time. As Hattangadi and Kelkar point out “In fact, the median holding period of the top 100 stocks by market capitalisation in the U.S. has shrunk to a third from about 600 days to 200 days over the last two decades.” Now contrast this data point with the fact that almost any and every stock market expert likes to tell us that stocks are for the long term.
This also happens because an inherent action bias is built into human beings. An interesting example of this phenomenon comes from football. “In an interesting research paper, Michael Bar-Eli2 et al analysed 286 penalty kicks in top soccer leagues and championships worldwide. In a penalty kick, the ball takes approximately 0.2 seconds to reach the goal leaving no time for the goalkeeper to clearly see the direction the ball is kicked. He has to decide whether to jump to one of the sides or to stay in the centre at about the same time as the kicker chooses where to direct the ball. About 80% of penalty kicks resulted in a goal being scored, which emphasises the importance a penalty kick has to determine the outcome of a game. Interestingly, the data revealed that the optimal strategy for the goalkeeper is to stay in the centre of the goal. However, almost always they jumped left or right,” write Hattangadi and Kelkar.
Albert Edwards of Societe Generale discusses this example in greater detail. As he writes “When a goalkeeper tries to save a penalty, he almost invariably dives either to the right or the left. He will stay in the centre only 6.3% of the time. However, the penalty taker is just as likely (28.7% of the time) to blast the ball straight in front of him as to hit it to the right or left. Thus goalkeepers, to play the percentages, should stay where they are about a third of the time. They would make more saves.”
But the goalkeeper doesn’t do that. And there is a good reason for it. As Hattangadi and Kelkar write “ The goalkeepers choose action (jumping to one of the sides) rather than inaction (staying in the centre). If the goalkeeper stays in the centre and a goal is scored, it looks as if he did not do anything to stop the ball. The goalkeeper clearly feels lesser regret, and risk to his career, if he jumps on either side, even though it may result in a goal being scored.”
Investors also behave like football goalkeepers and that hurts them.
The article originally appeared on www.firstbiz.com on February 8, 2014
(Vivek Kaul is a writer. He tweets @kaul_vivek)  

Is Eurozone trying to become a bigger Germany?

euroVivek Kaul

The US Department of Treasury publishes a semi-annual currency report. The latest report released on October 30, 2013, makes a scathing attack at Germany. “Germany has maintained a large current account surplus throughout the euro area financial crisis, and in 2012, Germany’s nominal current account surplus was larger than that of China. Germany’s anemic pace of domestic demand growth and dependence on exports have hampered rebalancing at a time when many other euro-area countries have been under severe pressure to curb demand and compress imports in order to promote adjustment. The net result has been a deflationary bias for the euro area, as well as for the world economy,” the report points out.
So what does this mean in simple English? Germany has been the export powerhouse of the world. It exports considerably more than it imports. This is the formula it has been trying to force onto other countries of the Eurozone as well. Eurozone is a term used for 17 countries which have adopted euro as their currency.
Some of these countries like Portugal, Spain, Italy, Greece, Ireland etc have not been in the best economic condition over the last few years, with a huge amount of private as well as government debt. This was a result of going overboard with their spending in the years before the financial crisis started.
As Albert Edwards of Societe Generale writes in a report titled Prepare for the next phase of global currency war – should we blame Germany? dated November 14, 2013, “In the run-up tothe crisis they all promoted an inappropriately loose monetary policy that caused a credit and housing bubble, runaway domestic demand growth, ostensibly sound government finances and burgeoning current account deficits, all financed by a surplus nation…predominately Germany.”
Countries like Portugal, Spain, Italy, Greece, Ireland etc went on a borrowing spree, which ultimately led to a housing bubble. When the bubble burst the banking system in these countries was in a mess. They had to be bailed out by the European Central Bank(ECB). At the same time countries were forced to follow austerity measures to control government expenditure. These measures have led to an extremely high level of unemployment in these countries. As Ambrose Evans-Pritchard of The Daily Telegraph pointed out in a recent column “unemployment is 27.8% in Greece, 26.3% in Spain, 17.3% in Cyprus, and 16.5% in Portugal.. it would be far worse had it not been for a mass exodus of EMU refugees….Greek youth unemployment is 62.9%.” 
This has led to a situation where internal demand in these countries fell dramatically. A fall in internal demand has meant lower imports. And this in turn has led to exports being greater than imports, and hence a trade surplus( a situation where exports of a country are greater than its imports). The eurozone trade surplus in August 2013 was at $9.5 billion.
Interestingly, the collapse of demand within these countries has also led to a situation where German exports within the Eurozone have fallen. “It is that actually Germany’s trade surplus within the Eurozone has collapsed to almost zero as the GIIPS(Greece, Italy, Ireland, Portugal and Spain)have plunged into depression,” writes Edwards.
This basically means that Germany is importing as much from other countries in the Eurozone as it is exporting to them, leading to a trade surplus of almost zero. But it has more than made up for this by running a higher trade surplus with other parts of the world, primarily United States and large parts of Asia.
 Hence, it isn’t surprising that the United States has a problem with Germany. While Germany is exporting goods and services to the United States, it isn’t importing the same amount back from the United States or other parts of the world for that matter. This means that businesses in the United States and other parts of the world are not exporting enough, which in turn has an impact on economic growth.
This formula of running a trade surplus by exporting more and limiting imports has worked very well for Germany. But the question is will it work for the Euro Zone as a whole? Martin Wolf of The Financial Times feels that the strategy may not work for two reasons. “First, the eurozone is far too big to achieve export-led growth, as Germany has done; and, second, the currency is likely to appreciate still further, thereby squeezing the less competitive economies all over again.”
The euro is likely to appreciate in the days to come given that both Japan and United States are printing money big time in the hope of devaluing their currencies. Also, this formula will have political complications as well, given that, exports can only happen if someone else is importing. Every country cannot be an exporter at the same time. Someone has to import as well.
And who will that importer be? Sanjeev Sanyal of Deutsche Bank writes in a report titled Bretton Woods III and the Global Savings Glut dated October 8, 2013 “Reinterpreted to present conditions, the next round of global economic expansion may require the US to revert to its role as the ultimate sink of global demand.”
Or as the French like to put it plus ça change, plus c’est la même chose.(the more things change, the more they stay the same).
The article was originally published on www.firstpost.com on November 15, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek) 

Once more! Fed is blowing bubbles to cover up growing inequality

Bernanke-BubbleVivek 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) 

Decoding Rajan’s Frankfurt speech: Why central banks fuel bubbles

 ARTS RAJANVivek Kaul  
Alan Greenspan, when he was the chairman of the Federal Reserve of United States, the American central bank, used to say “I know you think you understand what you thought I said but I’m not sure you realize that what you heard is not what I meant.”
Greenspan was known to talk in a very roundabout manner, never meaning what he said, and never saying what he meant. Thankfully, all central bank governors are not like that. There are some who like calling a spade a spade.
Raghuram Rajan, the governor of the Reserve Bank of India(RBI), was in Frankfurt yesterday to receive the Fifth Deutsche Bank Prize for Financial Economics. In his speech he said things that would have embarrassed central bank governors of the Western nations, who are busy printing money to get their economies up and running again.
In the aftermath of the financial crisis that started in late 2008, Western central banks have been printing money. With so much money going around, the hope is that interest rates will continue to remain low (as they have). At low interest rates people are likely to borrow and spend more. When they do that this is likely to benefit businesses and thus the overall economy.
But what has happened is that the citizens of the countries printing money are still in the process of coming out of one round of borrowing binge. When interest rates were at very low levels in the early 2000s, they had borrowed money to speculate in real estate in the hope that real estate prices will continue to go up perpetually. This eventually led to a real estate bubbles in large parts of the Western world.
Eventually, the bubbles burst and people were left holding the loans they had taken to speculate in real estate. Hence, people who are expected to borrow and spend, are still in the process of repaying their past loans. So, they stayed away from taking on more loans.
But money was available at very low interest rates to be borrowed. Hence, banks and financial institutions borrowed this money at close to zero percent interest rates and invested it in stock, real estate and commodity markets all around the world. Some of this money also seems to have found its way into fancier markets like art. And this has again led to several asset bubbles in different parts of the world. As Rajan put it in Frankfurt “We seem to be in a situation where we are doomed to inflate bubbles elsewhere.”
Economists still do not agree on what is the best way to ensure that there are no real estate or stock market bubbles. But what they do agree on is that keeping interest rates too low for too long isn’t the best way of going about it. It is a sure shot recipe for creating bubbles. Even the once great and now ridiculed “Alan Greenspan” agrees on this. In an article for the Wall Street Journal published in December 2007(after he had retired as the Fed chairman), he wrote “The 1% rate set in mid-2003…lowered interest rates…and may have contributed to the rise in U.S. home prices.”
What he was effectively saying was that by slashing the interest rate to 1%, the Federal Reserve of United States may have played a part in fuelling the real estate bubble in the United States. Rajan in his Frankfurt speech for a change agreed with Greenspan. As he said “We should wonder whether lower and lower interest rates are in fact part of the problem, I say I don’t know.”
It is easy to conclude from the statements of Greenspan as well Rajan that central bank governors do understand the perils of printing money to keep interest rates low. Given that why are they still continuing to print money? Ben Bernanke, the current Chairman of the Federal Reserve hinted in May 2013, that the Fed plans to go slow on money printing in the months to come. He repeated this in June 2013. But when the Federal Reserve met recently, nothing happened on this front and it decided to continue printing $85 billion every month.
As Albert Edwards of Societe Generale put it in a February 2013 report titled Is Mark Carney the Next Alan Greenspa…? “I keep seeing Central Bankers saying again and again that QE(quantitative easing, a fancy term for printing money) and more recently, helicopter money is not only necessary but essential.”
So the question is why do central banks in the Western world continue to print money? Dylan Grice, formerly of Societe Generale, has an answer in his 2010 report Print Baby Print. As he writes “What’s interesting is that central banks feel they have no choice. It’s not that they’re unaware of the risks…They’re printing money because they’re scared of what might happen if they don’t. This very real political dilemma… It’s like they’re on a train which they know to be heading for a crash, but it is accelerating so rapidly they’re scared to jump off.”
Sometimes the withdraw symptoms are so scary that it just makes sense to continue with the drug. Dylan compares the current situation to the situation that Rudolf von Havenstein found himself in as the President of the Reichsbank, which was the German central bank in the 1920s.
Havenstein printed so much money that it led to hyperinflation and money lost all its value. The increase in money printing did not happen overnight; it had been happening since the First World War started. By the time the war ended, in October 1918, the amount of paper money in the system was four times the money at the beginning of the war. Despite this, prices had risen only by 139%. But by the start of 1920, the situation had reversed. The money in circulation had grown 8.4 times since the start of the war, whereas the wholesale price index had risen nearly 12.4 times. It kept getting worse. By November 1921, circulation had gone up 18 times and prices 34 times. By the end of it all, in November 1923, the circulation of money had gone up 245 billion times. In turn, prices had skyrocketed 1380 billion times since the beginning of the First World War.
So why did Havenstein start and continue to print money? Why did he not stop to print money once its ill-effects started to come out? Liaquat Ahamed has the answer in his book The Lords of Finance. As he writes “were he to refuse to print the money necessary to finance the deficit, he risked causing a sharp rise in interest rates as the government scrambled to borrow from every source. The mass unemployment that would ensue, he believed, would bring on a domestic economic and political crisis.”
The danger for central bank governors is very similar. If they stop printing money then interest rates will start to go up and this will kill whatever little economic growth that has started to return. Hence, the choice is really between the devil and the deep sea.
As far as Rajan is concerned he is possibly back to where it all started for him. The Federal Reserve Bank of Kansas City, one of the twelve Federal Reserve Banks in the United States, organises a symposium at Jackson Hole in the state of Wyoming, every year.
The 2005 conference was to be the last conference attended by Alan Greenspan, as the Chairman of the Federal Reserve. Hence, the theme for the conference was the legacy of the Greenspan era. Rajan was attending the conference and presenting a paper titled “Has Financial Development Made the World Riskier?”
Those were the days when Greenspan was god. The United States was in the midst of a huge real estate bubble, but the bubble wasn’t looked upon as a bubble, but a sign of economic prosperity. The prevailing economic view was that the US had entered an era of unmatched economic prosperity and Alan Greenspan was largely responsible for it.
Hence, in the conference, people were supposed to say good things about Greenspan and give him a nice farewell. Rajan spoiled what was meant to be a send off for Greenspan. In his speech Rajan said that the era of easy money would get over soon and would not last forever as the conventional wisdom expected it to. “The bottom line is that banks are certainly not any less risky than the past despite their better capitalization, and may well be riskier. Moreover, banks now bear only the tip of the iceberg of financial sector risks…the interbank market could freeze up, and one could well have a full-blown financial crisis,” said Rajan.
In the last paragraph of his speech Rajan said it is at such times that “excesses typically build up. One source of concern is housing prices that are at elevated levels around the globe.”
He came in for a lot of criticism for his plain-speaking and calling a bubble a bubble. As he later recounted about the experience in his book Fault Lines – How Hidden Fractures Still Threaten the World Economy, “Forecasting at that time did not require tremendous prescience: all I did was connect the dots… I did not, however, foresee the reaction from the normally polite conference audience. I exaggerate only a bit when I say I felt like an early Christian who had wandered into a convention of half-starved lions. As I walked away from the podium after being roundly criticized by a number of luminaries (with a few notable exceptions), I felt some unease. It was not caused by the criticism itself…Rather it was because the critics seemed to be ignoring what going on before their eyes.”
The situation is no different today than it was in 2005, when Rajan said what he did. The central bank governors are ignoring what is going on before their eyes and that is not a good sign. Or as Rajan put it in Frankfurt “When they (central banks) say they are the only game in town, they become the only game in town.”
The article originally appeared on www.firstpost.com on September 27,2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)