Vivek 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)
Ben Bernanke
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 the Federal Reserve wants to continue blowing bubbles
Vivek Kaul
The decision of the Federal Reserve of United States to continue printing money to revive the American economy, has gone against what most experts and analysts had been predicting. The Federal Reserve had also been saying that it plans to start going slow on money printing sooner, rather than later. But that hasn’t turned out to be the case. So what happened there?
When in doubt I like to quote John Maynard Keynes. As Keynes once said “Both when they are right and when they are wrong, the ideas of economists and political philosophers are more powerful than is commonly understood. Indeed, the world is ruled by little else.” The current generation of economists in the United States and other parts of the world are heavily influenced by Milton Friedman and his thinking on the Great Depression.
Ben Bernanke, the current Chairman of the Federal Reserve of United States is no exception to this. He is acknowledged as one of the leading experts of the world on the Great Depression that hit the United States in 1929 and then spread to other parts of the world.
In 1963, Milton Friedman along with Anna J. Schwartz, wrote A Monetary History of United States, 1867-1960. What Friedman and Schwartz basically argued was that the Federal Reserve System ensured that what was just a stock market crash became the Great Depression.
Between 1929 and 1933 more than 7,500 banks with deposits amounting to nearly $5.7billion went bankrupt. With banks going bankrupt, the depositors money was either stuck or totally gone. Under this situation, they cut down on their expenditure further, to try and build their savings again.
If the Federal Reserve had pumped more money into the banking system at that point of time, enough confidence would have been created among the depositors who had lost their money and the Great Depression could have been avoided.
This thinking on the Great Depression came to dominate the American economic establishment over the years. In fact, such has been Friedman’s influence on the prevailing economic thinking that Ben Bernanke said the following at a conference to mark the ninetieth birthday celebrations of Friedman in 2002. “I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”
At that point of time Bernanke was a member of the board of governors of the Federal Reserve System. What Bernanke was effectively saying was that in the days and years to come, at the slightest sign of trouble, the Federal Reserve of United States would flood the financial system with money, as Friedman had suggested. That is precisely what Bernanke and the American government did once the financial crisis broke out in late 2008. And they have continued to do so ever since. Hence, their decision to continue with it shouldn’t come as a surprise because by doing what they are, the thinking is that they are trying avoid another Great Depression like situation.
Currently, the Federal Reserve prints $85 billion every month. It pumps this money into the financial system by buying government bonds and mortgage backed securities. The idea is that by flooding the financial system with money, the Federal Reserve will ensure that interest rates will continue to remain low. And at lower interest rates people are more likely to borrow and spend. When people spend more money, businesses are likely to benefit and this will help economic growth.
The risk is that with so much money going around in the financial system, it could lead to high inflation, as history has shown time and again. To guard against this risk the Federal Reserve has been talking about slowing down its money printing (or what it calls tapering) in the days to come.
Ben Bernanke, the Chairman of the Federal Reserve, first hinted about it in a testimony to the Joint Economic Committee of the American Congress on May 23, 2013.
As he said “if we see continued improvement and we have confidence that that is going to be sustained, then we could in — in the next few meetings — we could take a step down in our pace of purchases.” As explained earlier, the Federal Reserve puts money into the financial system by buying bonds (or what Bernanke calls purchases in the above statement).
Bernanke had hinted at the same again while speaking to the media on June 19, 2013, Bernanke said “If the incoming data are broadly consistent with this forecast, the Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year…And if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around mid-year.”
Given this, the market was expecting that the Federal Reserve will start to go slow on money printing, sooner rather than later. But that hasn’t happened. The consensus was that the Federal Reserve will start by cutting down around $10 billion of money printing i.e. reduce the money it prints every month to around $75 billion from the current $85 billion.
So why has the Federal Reserve decided to continue to print as much money as it had in the past, despite hinting against it in the past? Bernanke in a press conference yesterday said that conditions in the job market where still far from the Federal Reserve would like to see. The Federal Reserve was also concerned that if it goes slow on money printing it could have the effect of slowing growth. “In light of these uncertainties, the committee decided to await more evidence that the recovery’s progress will be sustained before adjusting the pace of asset purchases,” Bernanke said.
Let’s try and understand this in a little more detail. Federal Reserve’s one big bet to get the American economy up and running again has been in trying to revive the real estate sector which has suffered big time in the aftermath of the financial crisis.
This is one of the major reasons why the Federal Reserve has been printing money to keep interest rates low. But home loan(or mortgages as they are called in the US) interest rates have been going up since Bernanke talked about going slow on money printing. As the CS Monitor points out “Since Fed Chairman Ben Bernanke first mentioned the possibility of scaling back the Fed’s purchases this past June, the average rate for a 30-year fixed rate mortgage has surged over 100 basis points –sitting at 4.6 percent as of last week – and certain market indicators are showing signs of slowdown.” This has led to the number of applications for home loans falling in recent weeks.
Also, as interest rates have gone up some have EMIs. As an article in the USA today points out “after a mere hint of new policy spiked mortgage rates enough to add $120 a month, or 16%, to the monthly payment on the median-priced U.S. House.”
Higher interest rates leading to higher EMIs on home loans, obviously jeopardises the entire idea of trying to revive the real estate sector. New home sales in the United States dropped 13% in July. And this doesn’t help job creation. As the USA Today points out “At more than 4 jobs per new single-family home, that means a normal recovery in housing — not a 2005-like bubble — would add 3 million jobs…Moody’s Analytics says. Quick arithmetic tells you that 3 million new jobs would take 1.9 percentage points off the unemployment rate.”
And that is the real reason why the Federal Reserve has decided to continue printing $85 billion every month. Of course, one side effect of this is that a lot of this money will find its way into financial and other asset markets all around the world.
Investors addicted to “easy money” will continue to borrow money available at very low interest rates and invest in financial and other markets around the world. So the big bubbles will only get bigger. As economist Bill Bonner writes in a recent column “Works of art are selling for astronomical prices. High-end palaces and antique cars are setting new records. Is this reckless money hitting the stock market too?”
Or as a global fund manager told me recently “If you look at Sotheby’s and Christie’s, in the art market, they are doing extremely well. The same is true about the property market. Prices have gone up to $100,000 in places which are in the middle of a jungle in Africa. Why? There is no communication. No power lines there.”
The answer is very simple. The “easy money” being provided by the Federal Reserve will continue showing up in all kinds of places.
The article originally appeared on www.firstpost.com on September 19, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)
Five years after Lehman Brothers went bust, the same mistakes are being made
Vivek Kaul
Graham Greene’s fascinating book The End of an Affair starts with these lines: “A story has no beginning or end: arbitrarily one chooses that moment of experience from which to look back or from which to look ahead.”
If the current financial crisis were a story (which it is) its beginning would be on September 15, 2008, when Lehman Brothers, the smallest of the big investment banks on Wall Street, went bust. It was the largest bankruptcy in the history of the world. Lehman Brothers started a crisis, from which the world is still trying to recover.
While the American government and the Federal Reserve(the American central bank) let Lehman Brothers go under, the got together to save AIG, one of the largest insurance companies in the world, a day later. This was followed by a spate of other rescues in the United States as well as Europe. These rescues cost the governments around the world a lot of money. As Mark Blyth writes in Austerity – The History of a Dangerous Idea “The cost of bailing, recapitalizing, and otherwise saving the global banking system has been depending on…how you count it, between 3 and 13 trillion dollars. Most of that has ended up on the balance sheets of governments as they absorb the costs of the bust.”
It’s been five years since Lehman Brothers went bust. Hence, enough time has elapsed since the financial criss started, to analyse, if any lessons have been learnt. One of the major reasons for the financial crisis was the fact that governments across the Western world ran easy money policies, starting from the turn of the century. Loans were available at low interest rates.
People went on a borrowing binge to build and buy homes and this led to huge real estate bubbles in different parts of the world. Take the case of Spain. Spain ended up building many more homes than it could sell. Estimates suggest that even though Spain forms only 12 percent of the GDP of the European Union (EU) it built nearly 30 percent of all the homes in the EU since 2000. The country has as many unsold homes as the United States of America which is many times bigger than Spain.
Along similar lines, by the time the Irish finished with buying and selling houses to each other, the home ownership in the country had gone up to 87%, which was the highest anywhere in the world. A similar thing happened in the United States, though not on a similar scale.
Housing prices in America had already started to fall before Lehman Brothers went bust. After that the fall accelerated. As per the Case-Shiller Composite-20 City Home Price Index, housing prices in America had risen by 76% between mid of 2001 and mid of 2006. The first time the real estate prices came down was in January 2007, when the Case-Shiller Composite-20 City Home Price Index suggested that housing prices had fallen by a minuscule 0.05% between January 2006 and January 2007. This fall came nearly two and half years after the Federal Reserve started raising interest rates to control the rise in price of real estate.
The fall gradually accentuated and by the end of December 2007, housing prices had fallen by 9.1% over a one year period. The fall continued. And by December 2008, a couple of months after Lehman went bust, housing prices, had fallen by 25.5%, over a period of three years. The real estate bubble had burst and the massacre had started. Similar stories were repeated in other parts of the Western world. Soon, western economies entered into a recession.
Governments around the world started tackling this by throwing money at the problem. The hope was that by printing money and putting it into the financial system, the interest rates would continue to remain low. At lower interest rates people would borrow and spend more, and this in turn would lead to economic growth coming back.
Hence, the idea was to cure a problem, which primarily happened on account of excess borrowing, by encouraging more borrowing. The question is where did this thinking come from? In order to understand this we need to go back a little in history.
As Nobel Prize winning economist Robert Lucas said in a speech he gave in January 2003, as the president of the American Economic Association: “Macroeconomics was born as a distinct field in the 1940s, as a part of the intellectual response to the Great Depression. The term then referred to the body of knowledge and expertise that we hoped would prevent the recurrence of economic disaster.”
Given this, the economic thinking on the Great Depression has had a great impact on American economists as well as central bankers. This is also true about economists across Europe to some extent.
In 1963, Milton Friedman along with Anna J. Schwartz, wrote A Monetary History of United States, 1867-1960, which also had a revisionist history of the Great Depression. What Friedman and Schwartz basically argued was that the Federal Reserve System ensured that what was just a stock market crash in October 1929, became the Great Depression.
Between 1929 and 1933, more than 7,500 banks with deposits amounting to nearly $5.7 billion went bankrupt. This according to Friedman and Schwartz led to the total amount of currency in circulation and demand deposits at banks, plunging by a one third.
With banks going bankrupt, the depositors money was either stuck or totally gone. Under this situation, they cut down on their expenditure further, to try and build their savings again. This converted what was basically a stock market crash, into the Great Depression.
If the Federal Reserve had pumped more money into the banking system at that point of time, enough confidence would have been created among the depositors who had lost their money and the Great Depression could have been avoided.
This thinking on the Great Depression came to dominate the American economic establishment over the years. Friedman believed that the Great Depression had happened because the American government and the Federal Reserve system of the day had let the banks fail and that had led to a massive contraction in money supply, which in turn had led to an environment of falling prices and finally, the Great Depression.
Hence, it was no surprise that when the Dow Jones Industrial Average, America’s premier stock market index, had a freak crash in October 1987, and fell by 22.6% in a single day, Alan Greenspan, who had just taken over as the Chairman of the Federal Reserve of United States, flooded the financial system with money.
After this, he kept flooding the system with money by cutting interest rates, at the slightest hint of trouble. This led to a situation where investors started to believe that come what may, Greenspan and the Federal Reserve would come to the rescue. This increased their appetite for risk, finally led to the dotcom and the real estate bubbles in the United States.
In fact, such has been Friedman’s influence on the prevailing economic thinking that Ben Bernanke, who would take over as the Chairman of the Federal Reserve, after Greenspan, said the following at a conference to mark the ninetieth birthday celebrations of Friedman in 2002. “I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”
At that point of time, Bernanke was a member of the board of governors of the Federal Reserve System and hence, the use of the word “we”. What Bernanke was effectively saying was that in the days and years to come, at the slightest sign of trouble, the Federal Reserve of United States would flood the financial system with money.
And that is precisely what Bernanke and the American government did once the financial crisis broke out in September 2008. The Bank of England, the British central bank, followed. And so did the European Central Bank in the time to come. Recently, the Bank of Japan decided to join them as well.
Central banks around the world have been on a money printing spree since the start of the financial crisis in late 2008. Between then and early February 2013, the Federal Reserve of United States has expanded its balance sheet by 220%. The Bank of England has done even better at 350%. The European Central Bank came to the money printing party a little late in the day and has expanded its balance sheet by around 98%. The Bank of Japan has been rather subdued in its money printing efforts and has expanded its balance sheet only by 30% over the four year period. But during the course of 2013, the Bank of Japan has made it clear that it will print as much money as will be required to get the Japanese economy up and running again.
The trouble is that people in the Western world are not interested in borrowing money again. Hence, the little economic recovery that has happened has been very slow. The Japanese economist Richard Koo calls the current state of affairs in the United States as well as Europe as a balance sheet recession. The situation is very similar to as it was in Japan in 1990 when the stock market bubble as well as the real estate bubble burst.
Hence, Koo concludes that the Western economies including the United States may well be headed towards a Japan like lost decade. In a balance sheet recession a large portion of the private sector, which includes both individuals and businesses, minimise their debt. When a bubble that has been financed by raising more and more debt collapses, the asset prices collapse but the liabilities do not change.
In the American and the European context what this means is that people had taken on huge loans to buy homes in the hope that prices would continue to go up for perpetuity. But that was not to be. Once the bubble burst, the housing prices crashed. This meant that the asset (i.e. homes) that people had bought by taking on loans lost value, but the value of the loans continued to remain the same.
Hence, people needed to repair their individual balance sheets by increasing savings and paying down debt. This act of deleveraging or reducing debt has brought down aggregate demand and throws the economy in a balance sheet recession.
While the citizens may not be borrowing, this hasn’t stopped the financial institutions and the speculators from borrowing at close to zero percent interest rates and investing that money in various parts of the world. And that, in turn, has led to other asset bubbles all over the world.
These bubbles have benefited the rich. As The Economist points out “THE recovery belongs to the rich. It seemed ominous in 2007 when the share of national income flowing to America’s top 1% of earners reached 18.3%: the highest since just before the crash of 1929. But whereas the Depression kicked off a long era of even income growth the rich have done much better this time round. New data assembled by Emmanuel Saez, of the University of California, Berkeley, and Thomas Piketty, of the Paris School of Economics, reveal that the top 1% enjoyed real income growth of 31% between 2009 and 2012, compared with growth of less than 1% for the bottom 99%. Income actually shrank for the bottom 90% of earner.”
Once these bubbles start to burst, the world will go through another round of pain. Satyajit Das explains the situation beautifully in a recent column for the Financial Times, where he quotes the Irish author Samuel Beckett “Ever tried. Ever failed. No matter. Try Again. Fail again. Fail better.”
To conclude, there are many lessons that history offers us. But its up to us whether we learn from it or not. As the German philosopher Georg Engel once said “What experience and history teach is this – that nations and governments have never learned anything from history, or acted on principles deduced from it”. And why should this time be any different?
The article originally appeared on www.firstpost.com on September 16, 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)