Tag: Fault Lines | Vivek Kaul

20 August, 2015

Property prices must fall: Rajan reads out the riot act to real estate wallahs

Vivek Kaul

Raghuram Rajan, the governor of the Reserve Bank of India (RBI), merely stated the obvious when he said today (August 20, 2015): “It would be a “great help” if realty developers sitting on unsold stock bring down prices…Once the prices stabilise, more people will be keen to buy houses.”

The RBI governor added that property prices need to fall before interest rates on home loans come down, any further. “I think we need the market to clear. With growing unsold stock, we need to see the ways to do it. Some of it might be by making loans easier, but we also don’t want to create a situation where prices stay high at the level which means demand can’t pick up,” he said.

There are multiple points that need to be made here: First is that Rajan was essentially replying to all the real estate wallahs (real estate companies, lobbies and others associated with the sector) who demand interest rate cuts at a drop of a hat. The message from the RBI governor is loud and clear. The home prices are in a bubble zone and he does not want to inflate the bubble further by cutting interest rates. Home prices need to fall.

Also, it is worth mentioning here that even at high interest rates home loans given by banks continue to grow at a very brisk pace. The Reserve Bank of India (RBI) puts out the sectoral deployment of credit data every month. As per these numbers, the total amount of home loans given by banks grew by 15.6% to Rs 6,53,400 crore, over the last one year. In comparison, the overall lending by banks grew by just 7.3%. These numbers were as of June 2015.

How was the situation in June 2014? Home loans had grown by 17.1% to Rs 5,65,000 crore. In comparison the overall lending by banks had grown by 12.8%. What this clearly tells us is that even though the overall lending growth of banks has crashed from 12.8% to 7.3%, home loans continue to grow at a fairly brisk pace.
Further, banks have given out Rs 88,400 crore of home loans in the last one year. This formed around 21% of all the lending carried out by banks. For a period of one year ending June 2014 and June 2013, home loans formed around 12.7% and 12.2% of the total loans given by banks.

What this clearly tells us that banks are giving out a greater amount of home loans as a proportion of their overall loans, than they were in the past. And if this hasn’t led to a fall in inventory of unsold homes, the only reason is that home prices have gone up way beyond what most people afford. Hence, even though the total amount of home loans has gone up, the total number of home loans being given out may have even fallen (This data is not available).

The only way this situation can be corrected is if home prices fall, which is precisely what Rajan said.

The other interesting point that needs to be made here is that central bank governors normally stay away from calling a bubble, a bubble. Alan Greenspan, the Chairman of the Federal Reserve, from 1988 to 2006, was a pioneer in this school of thought. He told the US Congress in June 1999: “Bubbles are generally perceptible only after the fact. To spot a bubble in advance requires a judgment that hundreds of thousands of informed investors have it all wrong. Betting against markets is usually precarious at best.”

So, the Federal Reserve could not spot the dotcom bubble, explained Greenspan. But once it had burst, steps could be taken to ease its fallout, Greenspan felt. As he said in a speech titled Economic Volatility on August 30, 2002: “The notion that a well-timed incremental tightening could have been calibrated to prevent the late 1990s bubble is almost surely an illusion. Instead, we noted in the previously cited mid-1999 congressional testimony the need to focus on policies ‘to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion.’”

There is a fundamental problem with this argument. Greenspan was basically saying that the Federal Reserve could not recognize a bubble, but it could figure out when the same bubble had burst.

Raghuram Rajan exposes the flaw in this argument in his book Fault Lines. As he wrote: “This speech seemed to be a post facto rationalization of why Greenspan had not acted more forcefully on his prescient 1996 intuition: he was now saying the Fed should not intervene when it thought asset prices were too high but that it could recognize a bust when it happened and would pick up the pieces.” Greenspan had used the term “irrational exuberance” to describe the dotcom bubble in a speech he had made in December 1996, and then chosen to do nothing about it.

Rajan clearly does not believe in the fact that a central bank cannot identify a bubble. What he said today regarding property prices being high and that they need to fall, before people can start buying homes again, clearly proves that.

Further, the real estate wallahs seem to have come up with a new explanation for why real estate prices cannot fall any further(they have barely fallen to start with). As Shishir Baijal, chairman and managing director of Knight Frank India, a real estate consultancy, told Mint recently: “Theoretically, if prices come down, perhaps the demand can increase. But I’m not sure if developers have any leeway left now for reducing prices. This is because input cost has increased quite a lot over the past few years— be it cost of labour, construction and material, or even the historical cost of land itself, which is very high. It does not look like there is any scope left for a serious correction in prices.”

This, after he had said: “there is a mismatch [between demand and supply] because people are finding it unaffordable (to buy).”And this came, after he had said: “If you look at investor demand, property is not their primary choice anymore. This is due to muted price appreciation, high level of unsold inventory, and the fact that there are other more lucrative financial instruments to choose from. Earlier, there weren’t any options as the equity market was not performing.”
So, investors are not buying because they are not getting high returns from investing in real estate, anymore. The end users are not buying because prices are high. But prices will still not fall, say the real estate wallahs. What sort of an argument is that?

If home prices do not fall, the real estate sector will continue to remain in a mess for a much longer period of time. The market will go through what analysts call a longer time correction (i.e. prices will stagnate for a long period), if prices don’t fall. And this can’t possibly be good for anyone—buyers will continue to stay away, and sellers won’t be able to sell.

This will mean that the real estate companies will continue to hold on to unsold homes that they have accumulated over the years. Given this, Rajan was absolutely right when he said if the market has to function, and buy and sell transactions have to happen, home prices need to fall. The sooner the real estate wallahs understand this, the better it will be for all of us.

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

The article originally appeared on Firstpost.com on August 20, 2015

27 May, 2015

Why does Arvind Subramanian want India to outsource its monetary policy to the United States?

Arvind Subramanian, the chief economic adviser to the ministry of finance, has latched on to the finance minister Arun Jaitley’s formula. During the course of the last financial year, given half an opportunity, Jaitley asked the Reserve Bank of India (RBI) to cut interest rates.
Subramanian did the same yesterday when he said: “They (other countries) are aggressively easing monetary policy,” implying that the RBI should also cut the repo rate soon. Repo rate is the rate at which RBI lends to banks and acts as a sort of a benchmark to the interest rates that banks pay for their deposits and in turn charge on their loans.
Subramanian also went on to suggest that it was time that India started to imitate China on the currency front. As he said: “If you were to ask me how did China accumulate $4 trillion of reserves, it’s essentially buying it to keep the currency very, very competitive. So, it is a lesson for all of us. It is not what everything China does we should we imitate… but that is the lesson we should learn from.”
The above statement is nowhere as straightforward as it looks. Subramanian talks about China having accumulated $4 trillion of reserves in an effort to keep its currency, the yuan, competitive. What does he mean by this? Chinese exporters get paid in dollars (largely). When they get these dollars back to China, they need to convert them into yuan, given that their expenses are in yuan, they need to pay taxes in yuan and so on.
Hence, the exporters need to sell dollars and buy yuan. This would push up the demand for the yuan and lead to an appreciation of the yuan against the dollar. An appreciating yuan would not be good for exporters given that they would be paid fewer yuan when they convert their dollars into yuan.
Let’s consider the case of an exporter who makes a $1 million. If one dollar is worth 6.2 yuan (as it is now) the exporter would make 6.2 million yuan. But if one dollar has appreciated and is worth 6 yuan, then the exporter would make only 6 million yuan, which is lower. Hence, an appreciating yuan hurts.
Given that China is an export powerhouse, in the normal scheme of things, the yuan should have been appreciating against the dollar, over the years. And that would have hurt Chinese exports making them uncompetitive.
But that hasn’t happened. From October 2011 onwards the value of the dollar has ranged between 6.34 to 6.20 yuan Hence, when a Chinese exporter exports he has a fairly good idea of what kind of money he is going to make in terms of yuan. Between July 2008 and May 2010, the dollar was worth between 6.8 to 6.82 yuan.
The question is how does this happen? The People’s Bank of China, the Chinese central bank, keeps intervening in the foreign exchange market. It buys dollars and sells yuan. In the process it ensures that there are enough yuan going around in the financial system, and the value stays stable against the dollar.
Nevertheless, the intervention by the People’s Bank is not free of cost. As Raghuram Rajan writes in Fault Lines—How Hidden Fractures Still Threaten the Global Economy: “If it[i.e. the People’s Bank] intervenes a lot, the abundance of renminbi[another name for the Chinese yuan] in circulation will push up inflation.”
How does that happen? When the People’s Bank buys dollars, it has to sell yuan. Where does it get these yuan from? It prints them (or these days creates them digitally on a computer). The money supply in the financial system goes up. As a greater amount of money chases the same amount of goods and services, prices go up.
The People’s Bank has to avoid this. So what does it do? It carries out what is known as an sterilized intervention. The central bank also sells government bonds that it holds in its kitty. When it sells government bonds it gets paid in yuan. In the process, the People’s Bank manages to ensure that the total amount of yuan in the financial system does not go up dramatically, after it has carried out the intervention to hold the value of the yuan.
Then there is another problem. The dollars that the People’s Bank ends up holding in its kitty are primarily invested in bonds issued in dollars, which includes bonds issued by the United States government and its institutions.
The People’s Bank also needs to pay an interest on the government bonds it sells to suck out yuan from the financial system. The interest on these bonds needs to match the interest that the People’s bank earns by investing in the United States.
If the interest to be paid on the bonds being sold by the People’s Bank is higher than the interest that the People’s Bank is earning by investing in dollar assets, then there is a problem. As Rajan writes: “If the interest paid on dollar assets is low, while renminbi[another name for the Chinese yuan] interest rates are high, the central bank will effectively be holding a low-yield asset while issuing a high-yield liability—which means it will incur a loss. If this negative spread were multiplied by $2 trillion worth of foreign reserves(not all dollars, of course) that China has, it would blow a gigantic hole into the Chinese budget.” [The foreign exchange reserves are now $4 trillion, hence the hole would be bigger. Rajan’s book was published in 2010.]
This is something that cannot be allowed to happen. Hence what does China do? As Rajan writes: “A direct effect of such a policy is that China mirrors the United States’ monetary policy. If interest rates in the United States are very low. China also has to keep interest rates low. Doing so risks creating credit, housing and stock market bubbles in China, as much in the United States. With little freedom to use interest rates to counteract such trends, the Chinese authorities have to use blunt tools: for example, when credit starts growing strongly, the word goes out from the Chinese bank regulator that the banks should cut back on issuing credit.”
Getting back to the chief economic adviser Arvind Subramanian—what he is essentially suggesting is that like the People’s Bank of China, the RBI should also more actively manage the value of the rupee against the dollar, in order to benefit the exporters.
But as Rajan so beautifully explains in his book, what China has done comes with costs attached to it. The Chinese government has been able to manage the negatives because it can do things which other governments which are democratically elected cannot do.
Further, the Indian government (or the RBI) does not have the same control over banks as the Chinese government does. During the last financial year, many statements were made to get banks to cut interest rates and increase lending. But that never happened. Also, India has a thriving private banking sector, over which the government has next to no control.
To conclude, why does Subramanian want India to outsource its monetary policy to the United States? This is something only he can tell us.

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

The column originally appeared on Firstpost on May 27, 2015

16 August, 2014

Global market bubbles: Raghuram Rajan will have the last laugh second time around

Vivek Kaul

The Federal Reserve Bank of Kansas City is one of the 12 Federal Reserve banks in the United States. Every year in August it organizes a symposium at Jackson Hole in the state of Wyoming. The conference of 2005 was to be the last conference attended by Alan Greenspan, the then Chairman of the Federal Reserve of the United States, the American central bank.
The theme of the symposium was the legacy of the Greenspan era. Those were the days when Greenspan was god, and hence, the economists who had turned up at the conference, were expected to say good things about him and his time as the Chairman of the Federal Reserve of United States, which had lasted close to two decades.
One of the economists attending the conference was Raghuram Rajan, who at that point of time was the Chief Economist of the International Monetary Fund. Rajan presented a paper titled “Has Financial Development Made the World Riskier?” at the conference.
As Neil Irwin writes in The Alchemists—Inside the Secret World of Central Bankers “Raghuram Rajan presented a rare moment of clarity at the 2005 conference. Rajan indeed had an astute understanding of the ways in which the financial industry, with misguided compensation policies that encouraged risk-taking, was making the world a more dangerous place: Bankers were paid big bonuses for making money in the short run even if they were betting poorly in the long run.”

Rajan in his speech also suggested that banks were not in the best shape as was being made out to be. As he put it “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.”
In the last paragraph of his speech Rajan said that “One source of concern is housing prices that are at elevated levels around the globe.” Rajan’s speech did not go down well with people at the conference. This is not what they wanted to hear.
Rajan recounts the situation in his book Fault Lines – How Hidden Fractures Still Threaten the World Economy: “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.”
Rajan’s prediction turned out to be right in the end and a little over three years later in September 2008, the world was in the midst of a full-blown financial crisis, the impact of which is still being felt, almost six years later. Banks and financial institutions about the go bust had to be rescued by governments all over the Western world. Also, in the aftermath of the crisis, Western governments and their central banks decided to print trillions of dollars in order to get their economies up and running again.
Now Rajan has sounded a warning again.
In an interview to the Central Banking Journal which was published a few days back Rajan said “The problems arising are not so much from credit growth, which is relatively tepid in the industrial markets and has been much stronger in emerging markets, but from asset prices due to financial risk-taking and so on. Unfortunately, a number of macroeconomists have not fully learned the lessons of the great financial crisis. They still do not pay enough attention – en passant – to the financial sector. Financial sector crises are not as predictable. The risks build up until, wham, it hits you. So it is not like economic growth, where unemployment offers a more continuous indicator.”
What Rajan is essentially saying here is that all the money printed and pumped into the financial system by the American and other Western governments has led to financial market bubbles all over the world. And these bubbles when they burst will lead to another financial crisis. As Rajan put it “We are taking a greater chance of having another crash at a time when the world is less capable of bearing the cost.”
Rajan went on to suggest that central banks have had a role to play in creating financial market bubbles all across the world. As he put it “The kind of language we hear is akin to gaming. Investors say, ‘we will stay with the trade because central banks are willing to provide easy money a
nd I can see that easy money continuing into the foreseeable future’. It’s the same old story. They add ‘I will get out before everyone else gets out’.”
In another interview to the Time magazine published on August 11, 2014, Rajan said “A number of years over which we, as central bankers, have convinced markets that we continuously come to their rescue and that we will keep rates really low for long — that we do all kinds of ways of infusing liquidity into the markets — has created markets that tend to push asset prices probably significantly beyond fundamentals, in some cases, and make markets much more vulnerable to adverse news.”
One of the reasons for the bubbles is the fact that compensation structures which encourage high financial risk-taking are back on Wall Street. The following table makes for a very interesting reading.

Source: The Office of New York State Comptroller

In 2007 and 2008, the Wall Street firms faced huge losses. But their employees still got their bonuses. In fact, in 2007, the total bonus had stood at $33 billion. This, when firms had faced losses of $11.3 billion.
In the year 2009, the Wall Street firms made a profit of $61.4 billion because of all the bailout money given by the government. Even during the heydays of the bull run between 2003 and 2006, the firms had not made that kind of money.
Interestingly, if one looks at the bonus-to-profit ratio between 2003 and 2006, it stands at 1.55. For the period after the financial crisis, between 2010 and 2013, the ratio stands at 1.48. There is not much material difference between the two ratios.
What this clearly tells us is that the bonus paid as a proportion of profits continues to remain high among Wall Street firms. Hence, the “risk” that these high bonuses built into the American financial system continues. As Michael Lewis writes in Flashboys: “Once the very smart people are paid huge sums of money to exploit the flaws in the financial system, they have the spectacularly destructive incentive to screw the system further, or to remain silent as they watch it being screwed by others.”
What Rajan had warned about in 2005 continues unabated and that has led to financial market bubbles all over the world. The real estate bubbles which played a major role in the financial crisis which started in September 2008, are also back with a bang. As Albert Edwards of Societe Generale wrote in a research note titled Here we go again…and once again no-one is listening “We are in the midst of the mother of all housing bubbles.
The economist Nouriel Roubini wrote in a November 2013 column “Now, five years later, signs of frothiness, if not outright bubbles, are reappearing in housing markets in Switzerland, Sweden, Norway, Finland, France, Germany, Canada, Australia, New Zealand, and, back for an encore, the UK (well, London). In emerging markets, bubbles are appearing in Hong Kong, Singapore, China, and Israel, and in major urban centers in Turkey, India, Indonesia, and Brazil.”
Over and above this the stock market in the United States continues to rise. As investment newsletter writer Gary Dorsch puts it in a June 2014 column “The “Least Loved” Bull market is still running on steroids, even at 63-months old. The median lifetime of the Top-12 Bull markets is 55-months. So it’s lasted 8-months beyond its mid-life. A -10% correction hasn’t happened for the past 34-months, far beyond the average of 18-months between corrections.”
And when these bubbles start bursting all over again, as they are bound to do, there will be trouble along the lines Rajan has been talking about. He might have the “last laugh” second time around as well. Though until that happens he may still be the “early Christian who [has] wandered into a convention of half-starved lions”.

The article was originally published on www.Firstbiz.com on August 14, 2014

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

25 June, 2014

Of financial inequality and the financial crisis

Thomas Piketty, a French economist, has taken the world by storm. His book Capital in the Twenty-First Century has been the second bestselling book on Amazon.com for a while now. Originally written in French, the book was translated into English and released a few months back in the United States.
Piketty’s Capital is not like some of the recent popular books in economics like Freakonomics or The Undercover Economist. It is a book running into 577 pages (if we ignore the notes running into nearly 80 pages) and is not exactly a bedtime read.
My idea is not to summarize the book in this column. That would be doing grave injustice to the book. Nevertheless I wanted to discuss an important point that the book makes.
A major but not so well discussed reason behind the financial crisis was the increasing inequality in the United States. Piketty discusses this in great detail in Capital.
The top 10% of the American population earned a little more than 50% of the national income on the eve of the financial crisis and then again in the early 2010s. In fact, if we look at income without capital gains, the top 10% earned more than 46% of the national income in 2010, which is already significantly higher than the income level attained in 2007, before the financial crisis started. The trend continued in 2011-2012 as well. In 1976, the top 10% of households earned around 33% of the national income.
The situation becomes even more grim when we look at the top 1% of the population. The top 1% of the households accounted for only 7.9% of total American wealth in 1976. This would grow 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.
A major reason for this inequality has been the pace at which the salaries of the top management of American companies have gone up. As Piketty writes“We’ve gone from a society of rentiers to a society of managers…Top managers[who Piketty calls supermanagers] have the power to set their own remuneration…or by corporate compensation committees whose members usually earn comparable salaries…in some cases without limit and in many cases without any clear relation to their individual productivity, which in any case is very difficult to estimate in a large organization.” This phenomenon was seen mainly in the United States, writes Piketty. But it was seen to a lesser extent in Great Britain and other English speaking developed countries in both the financial as well as non financial sectors.
In fact, Piketty even calls this phenomenon of senior managers being paid very high salaries as a form of “meritocratic extremism” or the need of modern societies, in particular the American society, to reward certain individuals deemed to be as “winners”. Interestingly, research shows that these winners got paid for luck more often than not. It shows that salaries went up most rapidly when sales and profits went up due to external reasons.
The solution to this increasing inequality of income was to some extent more education. But that is something that would take serious implementation and at the same time results wouldn’t have come overnight. How does a politician who has to go back to the electorate every few years deal with this? He needs to plan and think for the long run. But at the same time he needs to ensure that his voters keep electing him. If the voters don’t keep electing him in the short run there is nothing much he can do to improve things in the long run.
This is precisely what happened in the United States. Politicians addressed the issue of inequality by making sure that easier credit was accessible to their voters. Raghuram Rajan, currently the governor of the Reserve Bank of India, explains this very well in his award winning book Fault Lines: How Hidden Fractures Still Threaten the World Economy: “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.”
Hence, the palliative proposed by politicians for the increasing income inequality in America was easy credit. As Michael Lewis writes in The Big Short – A True Story “How do you make poor people feel wealthy when wages are stagnant? You give them cheap loans.”
While, the government and the politicians worked towards making borrowing easier, there is another point that needs to be made here. As income levels stagnated at lower levels, a large section of the population had to resort to taking on debt and this contributed to the financial instability of the United States. As Piketty writes in Capital “One consequences of increasing inequality was virtual stagnation of the purchasing power of the lower and middle classes…which inevitably made it more likely that modest households would take on debt, especially since unscrupulous banks and financial intermediaries….eager to earn good yields on enormous savings injected into the system by the well-to-do, offered credit on increasingly generous terms.”
So, it worked both ways. The government made it easier to borrow and the people were more than willing to borrow. As author Satyajit Das puts it “Borrowing became a substitute for rising incomes.”
This wasn’t surprising given that the minimum wage in the United States when measured in terms of purchasing power reached its maximum level in 1969. At that point of time the wage stood at $1.60 an hour or $10.10 in 2013 dollars, taking into account the inflation between 1968 and 2013. At the beginning of 2013, it was at $7.25 an hour, lower than that in 1969, in purchasing power terms.
The easy money strategy that has been followed in the aftermath of the financial crisis has again worked led to increasing inequality. The American stock market has rallied by more than 150% in the last five years and this has benefited the richest Americans.
In the five year bull run, the stock market generated a paper wealth of more than $13.5 trillion. In fact, in 2013, the market value of listed stocks in the United States went up by $4 trillion. This benefited the top 10% of Americans who own 80% of the shares listed on stock exchanges.
A similar thing happened in the United Kingdom, where the Bank of England admitted in 2012 that its quantitative easing program boosted the value of stocks and bonds by 25% or about $970 billion. Almost 40% of these gains went to the richest 5% of the British households.
Interestingly, the salaries of CEOs in the United States have continued to go up, even after the financial crisis. If one considers the Fortune 500 companies, the average CEOs salary is 204 times that of their rank and file workers. This disparity has gone by 20% since 2009.
At the same time, the income of the median American household fell to $51,404 in February 2013. This was 5.6% lower than what it was in June 2009. Further, the average income of the poorest 20% of the Americans has fallen by 8% since 2009. Given this, more than 100 million Americans are receiving some form of support from the government.
In fact new research carried out by Emmanuel Saez and Thomas Piketty reveals that between 2009 and 2012, the top 1% of income earners in the United States enjoyed a real income growth of 31%. Income for the bottom 90% of the earners shrank.
The point being that the Western world does not seem to have learnt from its past mistakes. As George Akerlof and Paul Romer wrote in a research paper titled Looting: The Economic Underworld of Bankruptcy for Profit, “If we learn from experience, history need not repeat itself.”If only that were the case!

Note: Not all data has been sourced from Thomas Piketty’s Capital in the Twenty-First Century. Some numbers have been sourced from Raghuram Rajan’s Fault Lines.

The article originally appeared in the June 2014 edition of the Wealth Insight magazine

(Vivek Kaul is the author of the Easy Money trilogy. He can be reached at [email protected])

3 October, 2013

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)