Federal Reserve of United States

Is the stock market rally for real or will the bubble burst soon?

bubble

The BSE Sensex closed at 28,177 points on November 17, up by around half a percent from its last close. Its been good going for the Sensex, having rallied by 33.3% since the beginning of this year. This probably led to a reader asking me on Twitter whether the stock market rally was for real or would the bubble burst soon?
These are essentially two questions here. First, whether the current rally is a bubble? Second, how long will it last? These are not easy questions to answer. Also, instead of trying to figure out whether the current rally is a bubble or not, I will stick to answering the second question, that is, how long will the current rally last.
As I have written on a few occasions in the past, the current rally is being driven by foreign institutional investors (FIIs). The domestic institutional investors(DIIs) have had very little role to play in it. The FIIs have made a net investment of a little over Rs 68,000 crore since the beginning of the year. During the same period the DIIs have made net sales of Rs 32,468 crore.
This data makes it very clear who has been driving the market up. Given this, instead of trying to figure out whether the current market is a bubble or not, it makes more sense to figure out whether the FIIs will keep bringing in fresh money into the Indian stock market.
The foreign investors have been borrowing money at very low interest rates and investing it in financial markets all around the world. They have been able to do that because Western central banks have been printing money to maintain low interest rates.
The Federal Reserve of the United States (the American central bank) recently decided to stop printing money and almost at the same time, the Bank of Japan decided to increase it. The Japanese central bank will now print around 80 trillion yen per year. The central bank had been printing around 60-70 trillion yen since April 2013, when it got into the money printing party, big time.
Like other central banks it pumped this money into the financial system by buying bonds. Interestingly, the size of the balance sheet of the Bank of Japan stood at around 164.8 trillion yen in March 2013. Since then, it has increased dramatically and as of October 2014 stood at 286.8 trillion yen.
The Bank of Japan hopes that by printing money it will manage to create some inflation. Once people see the price of goods and services going up, they will go out and shop, in the hope of getting a better deal. Also, with all the money printed and pumped into the financial system, interest rates will continue to remain low. And at low interest rates people were more likely to borrow and spend. Once people start to shop, it will lead to economic growth. Japan has had very little economic growth over the last two decades.
The trouble is that the Japanese aren’t falling for this oft tried central bank formula. And there is a clear reason for it. James Rickards in his book The Death of Money explains the point using what Eisuke Sakakibara, a former deputy finance minister of Japan, said in a speech on May 31, 2013, in South Korea.
As Rickards writes “Sakakibara…pointed out that Japanese people are wealthy and have prospered personally despite decades of low nominal growth. He made the often-overlooked point that because of Japan’s declining population, real GDP per capita will grow faster than aggregate GDP. …Combined with the accumulated wealth of the Japanese people, this condition can result in well-to-do-society even in the face of nominal growth that would cause central bankers to flood the economy with money.”
The question to ask here is will the Japanese continue to print money? The answer is yes. The Japanese politicians are desperate to create some inflation and the central bank has decided to get into bed with them. Also, more than that the Japanese government spends much more than it earns and needs to be bailed out by the Bank of Japan.
As analyst John Mauldin wrote in a recent column titled The Last Argument of Central Banks “According to my friend Nouriel Roubini, in 2013 Japan’s total tax revenue fell to a 24-year low. Corporate tax receipts fell to a 50-year low. Japan now spends more than 200 yen for every 100 yen of tax revenue it receives. It is likely Japan will run an 8% fiscal deficit to GDP this year, but the Bank of Japan is currently monetizing at a rate of over 15% of GDP, thereby theoretically reducing the level of debt owed by government institutions other than the central bank.”
Fiscal deficit is the difference between what a government earns and what it spends.
What Mauldin basically means is that a part of the debt raised by the Japanese government is being repaid through the Bank of Japan printing money and lending it to the government. With all this money continuing to float around in the financial system, interest rates in Japan will continue to remain low.
This will allow large financial institutions to borrow money at low interest rates in Japan and invest it in financial markets all over the world, including India.
The European Central Bank (ECB) also seems to be in the mood to start quantitative easing (QE, i.e. printing money to buy bonds). As Mohamed A. El-Erian, Chief Economic Adviser at Allianz wrote in a recent column “In fact, ECB President Mario Draghi signaled a willingness to expand his institution’s balance sheet by a massive €1 trillion ($1.25 trillion).”
While the United States might have decided to stop printing money, Japan and the Euro Zone, want to take a shot at it. Interestingly, chances are that the United States might go back to money printing in the years to come. As Niels C. Jensen writes in The Absolute Return Letter for November 2014 “If my growth expectations are about correct, QE is far from over – at least not in some parts of the world, and it is even possible that the Fed[the Federal Reserve of the United States] will come creeping back after having distanced itself from QE recently.”
The Federal Reserve of the United States has been financing the American fiscal deficit by printing money and buying treasury bonds issued by the government. In mid September 2008, around the time the financial crisis started, the Fed held treasury bonds worth $479.8 billion dollars. Since then, the number has shot up dramatically and as on October 29, 2014, it stood at $2.46 trillion dollars.
The fiscal deficit of the United States government shot up in the aftermath of the financial crisis. It was financed by more than a little help from the Federal Reserve. Nevertheless, the fiscal deficit has now been brought down. As Mauldin points out “The 2014 government deficit will be only 2.8% of GDP (it last saw that level in April 2005), the first time in a long time it has been below nominal GDP.”
The bad news is that the fiscal deficit will start rising again in 2016. “It is projected to fall again next year before rising in 2016. For the United States, this represents a reprieve, allowing us some time to deal with potential future problems before government spending rises to a proportion of income that is impossible to manage without severe economic repercussions. Government spending on mandated social programs will rise more than 50%, from $2.1 trillion this year to $3.6 trillion in 2024, potentially blowing the deficit out of control,” writes Mauldin.
The Federal Reserve might have to start printing money again in order to finance the government fiscal deficit.
Moral of the story: There are enough reasons for the Western nations to continue printing money and ensuring low interest rates. This means, FIIs can continue to borrow money at low interest rates and invest it in financial markets all over the world, including India.
The easy money party hasn’t ended. The only condition here is that the current government should not create a negative environment like the previous one did.
To conclude, the difficult thing to predict is, until when will this easy money party continue. I don’t have any clue about it. Do you, dear reader?

The article originally appeared on www.equitymaster.com on Nov 18, 2014

Fed may be reducing easy money, but here’s why Sensex will keep soaring

yellen_janet_040512_8x10Vivek Kaul

In theory there is no difference between theory and practice. In practice there is.

– Yogi Berra

A question I am often asked is why are the stock markets around the world still rallying despite the Federal Reserve of United States going slow on printing money. In a statement released yesterday the Fed decided to cut down further on money printing.
It will now print $15 billion per month instead of the earlier $25 billion. This was the seventh consecutive cut of $10 billion. Since December 2012, the Federal Reserve had been printing $85 billion per month. This money was pumped into the financial system by buying mortgage backed securities and government bonds. The idea was that by increasing the amount of money in the financial system, long term interest rates could be driven lower. The hope was that at lower interest rates, people would borrow and spend more.
From January 2014, the Federal Reserve decided to buy bonds worth $75 billion a month, instead of the earlier $85 billion. This meant that the Fed would be printing $75 billion a month instead of the earlier $85 billion. This cut in money printing came to be referred to as “tapering”, which means getting progressively smaller. Since then the amount of money being printed by the Federal Reserve has been tapered to $15 billion per month. At this pace the Federal Reserve should be done at dusted with its money printing by next month i.e. October 2014.
A lot of this printed money instead of being lent out to consumers has found its way around into stock markets and other financial markets around the world. The Dow Jones Industrial Average, America’s premier stock market index, has rallied more than 30% since October, 2012. This when the American economy hasn’t been in the best of shape.
The FTSE 100, the premier stock market index in the United Kindgom, has given a return of 15% during the same period. The Nikkei 225, the premier stock market index of Japan has rallied by 53% during the same period. Closer to home, the BSE Sensex has rallied by around 43% during the same period.
Stock markets around the world have given fabulous returns, despite the global economy being down in the dumps. The era of easy money unleashed by the Federal Reserve has obviously helped.
Nevertheless, the question is with the Fed clearly signalling that the easy money era is now coming to an end, why are stock markets still holding strong? One reason is the fact that even though the Fed might be winding down its money market operations, other central banks are still continuing with it.
The Bank of Japan, the Japanese central bank is printing around ¥5-trillion per month and is expected to do so till March 2015. The European Central Bank is also preparing to print €500-billion to €1-trillion over the next few years. What this means is that interest rates in large parts of the Western world will continue to remain low. Hence, big institutional investors can borrow from these financial markets and invest the money in stock markets around the world.
The second and more important reason is that the Federal Reserve does not plan to shrink its balance sheet any time soon. Before the financial crisis started in September 2008, the size of the Federal Reserve balance sheet stood at $925.7 billion. Since then it has ballooned and as on August 27, 2014, it stood at $4.42 trillion.
The size of the Fed balance sheet has exploded by close to 378% over the last six years. This has happened primarily because the Fed has printed money and pumped it into the financial system by buying bonds, in the hope of keeping interest rates low and getting people to borrow and spend.
Janet Yellen, the current Chairperson of the Federal Reserve made it very clear yesterday that the Fed was in no hurry to withdraw this money from the financial system. It could take to the “end of the decade” to shrink the Fed’s huge balance sheet “to the lowest levels consistent with the efficient and effective implementation of policy.”
What this essentially means is that the money that the Fed has printed and pumped into the financial system by buying bonds, will not be suddenly withdrawn from the financial system. When a bond matures, the institution which has issued the bond, repays the money invested to the institution that has invested in it.
If the investor happens to be the Federal Reserve, the maturing proceeds are paid to it. This leads to the amount of money in the financial system going down, and could lead to interest rates going up, as money becomes dearer.
This is something that the Fed does not want, in order to ensure that individuals continue borrow and spend money, and this, in turn, leads to economic growth. Hence, the Fed will use the money that comes back to on maturity, to buy more bonds and in that way ensure that total amount of money floating in the financial system does not go down.
This means that long term interest rates will continue to remain low. Hence, investors can continue to borrow money at low interest rates and invest that money in different parts of the world.
Yellen also clarified that short-term interest rates are also not going to go up any time soon. As she said “economic conditions may for some time warrant keeping the target federal funds rate below levels the committee views as normal in the longer run.”The federal funds rate is the interest rate that banks charge each other to borrow funds overnight, in order to maintain their reserve requirement at the Federal Reserve. This interest rate acts as a benchmark for short-term loans.
Given these reasons, the stock markets around the world will continue to rally, at least in the near term, as the era of easy money will continue. These rallies will happen, despite global growth being down in the dumps and the fact that the global economy is still to recover from the financial crisis that started just about six years and three days back, when the investment bank Lehman Brothers went bust on September 15, 2008.
To conclude, Ben Hunt who writes the Epsilon Theory newsletter put it best in a recent newsletter dated September 8, 2014, and titled The Ministry of Markets: “No one doubts the omnipotence of central banks. No one doubts that market outcomes are fully determined by central bank policy. No one doubts that central banks are large and in charge. No one doubts that central banks can and will inflate financial asset prices. And everyone hates it.”
The article appeared originally on www.FirstBiz.com on Sep 18, 2014

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

Five years later: It's time Western countries stopped printing money

helicash Vivek Kaul  
It was around this time in 2008, that the Federal Reserve of United States, the American central bank, started printing money to buy bonds. This process came to be referred as quantitative easing(QE) and gradually spread to other central banks in the Western world.
When the process was first initiated many writers (including yours truly) said that high inflation was on its way in the United States. Comparisons were made to Zimbabwe which was facing hyperinflation at that point of time.
In July 2008, a few months before the financial crisis broke out, the British newspaper Guardian reported that ordinary hen’s eggs were selling at $50billion each. These were not American dollars, but dollars issued by the Reserve Bank of Zimbabwe. Between August 2007 and June 2008, the money supply in Zimbabwe had gone up 20 million times.
With the money supply increasing by such a huge amount, inflation went through the roof. In early 2008, consumer price inflation was said to be at 2 million percent. By the end of the year it had reached around 230 million percent.
The feeling was that United States was headed towards something similar, though not of a similar proportion. Five years on, people who felt that way, continue to be proven wrong. Inflation levels in the United States and much of the Western world continue to remain very low. The consumer price inflation in the United States was at 1% in October 2013. This is the lowest it has been at since October 2009.
So the question is why is there has been no inflation? As Niels C Jensen writes in The Absolute Return Letter dated November 7, 2013 “The reality is that we have seen plenty of inflation already from QE – just not in the places nearly everyone expected it to show up. Asset price inflation is also inflation, and we have had asset price inflation galore. Many emerging economies have struggled with consumer price inflation in recent times. It looks as if we have been very good at exporting it.”
Countries printed money with the intention of ensuring that there would be enough money going around in the financial system and this would lead to low interest rates.
At lower interest rates people would borrow and spend more, and this in turn would revive economic growth, which had dried up in the aftermath of the financial crisis, which broke out in September 2008, after investment bank Lehman Brothers went bust.
But people had other ideas. They had borrowed and speculated in the real estate market between 2002 and 2008. Once the real estate bubble burst, they were left hanging onto homes, with considerably lower market values. The loans that people had taken still needed to be repaid. Hence, they wanted to repair their individual balance sheets and did not want to take on any more loans. They were more interested in repaying their outstanding loans.
In this scenario, there was little demand for loans from individuals. Financial firms cashed in on this by borrowing money at close to 0% interest rates and investing it in financial and other markets all over the world. And this has led to what economists call asset price inflation, where stock markets and other markets, are at very high levels, even though the underlying fundamentals don’t justify that. The trouble is when these bubbles burst they will create their own set of problems.
There is another reason behind why people are not borrowing even though interest rates are at very low levels. Jensen calls this the impact of the rational expectations hypothesis. As he writes “economic agents (read: consumers and businesses) make rational decisions based on their expectations. So, when the Fed – and other central banks with it – keep ramming home the same message over and over again (and I paraphrase): “Folks, we will keep interest rates low for some considerable time to come”, consumers and businesses only behave rationally when they postpone consumption and investment decisions. They have seen with their own eyes that central bankers have been able to talk interest rates down, so why borrow today if one can borrow more cheaply tomorrow?”
So the longer people postpone their borrowing, the longer government and central banks will have to keep printing money in order to keep interest rates low, in order to entice them to borrow.
In fact, interest rates are so low that banks are also not in the mood to lend. They would rather use the money that they have in proprietary trading activities. This explains to a large extent why financial firms have been borrowing and investing money in financial markets all over the world. While, money printing hasn’t exactly led to what central banks thought it would lead to, it has benefited governments tremendously. This is primarily because money printing has ensured that interest rates continue to remain at low levels and has allowed governments to borrow easily at ridiculously low interest rates.
As William White writes in a research paper titled Ultra Easy Monetary Policy and the Law of Unintended Consequences “Indeed, long term sovereign rates in the US, Germany, Japan and the UK followed policy rates down and are now at unprecedented low levels. However, there can be no guarantee that this state of affairs will continue. One disquieting fact is that these long rates have been trending down, in both nominal and real terms, for almost a decade…Many commentators have thus raised the possibility of a bond market bubble that will inevitably burst.”
This has led to government debts exploding. “Italy’s government debt has jumped from 121% to 132% of GDP over the past two years alone. Spain’s debt-to-GDP has gone from 70% to 94% and Portugal from 108% to 124% over the same period. An interesting brand of austerity I might add! Expanding the government deficits at such speed would have been devastatingly expensive in the current environment without QE,” writes Jensen.
Money printing has been bad for old people. The corpus they had saved for their retirement has hardly been able to generate an income that is good enough to live on. This has impacted people in the United States as well as Europe.
Also, a new stream of research coming out seems to suggest that money printing has an impact on income growth and in turn economic growth. “Charles Gave of GaveKal Research produced a very interesting paper earlier this year, linking the low income growth to QE – another nail in the coffin for economic growth. Charles found that during periods of negative real interest rates (which is a direct follow-on effect from QE), income growth in the U.S. has been low or negative,” writes Jensen.
This is primarily because when interest rates have been low for a very long period of time and are expected to be low for the years to come, there is very little incentive for the private sector to either hire new workers or increase capital spending. And when this happens income growth is more than likely to stagnate. This has an impact on consumer demand, which in turn influences economic growth.
John Mauldin captured this idea beautifully in a recent column where he wrote “The belief is that it is demand that is the issue and that lower rates will stimulate increased demand (consumption), presumably by making loans cheaper for businesses and consumers. More leverage is needed! But current policy apparently fails to grasp that the problem is not the lack of consumption: it is the lack of income.”
Once these factors are taken into account it is easy to suggest that it is time that the Western central banks and governments wound up their money printing plans. It is time for quantitative easing to come to an end. As Jensen puts it “It is time to call it quits. QE proved to be a very effective crisis management tool, but we have probably reached a point where the use can no longer be justified on economic grounds. The obvious problem facing policy makers, though, is that if financial markets are the patient, QE is the drug that keeps the underlying symptoms under control.”
Financial firms have been able to borrow money at close to 0% interest rates and invest it in financial markets all over the world. This is because quantitative easing or money printing has managed to keep interest rates at very low levels. Once money printing is stopped or even slowed, interest rates will start to rise. This will mean that asset bubbles all over the world will start to burst, which will create its own set of problems.
And that is the real problem. The question is who will blink first? The central banks or the financial markets?
The article originally appeared on www.firstpost.comon November 27, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)  
 
 

Debt ceiling: Why the Great American Ponzi scheme might just keep running

 
3D chrome Dollar symbolVivek Kaul 
Governments typically spend more than they earn. This difference is referred to as the fiscal deficit. The government of the United States (US) is no different on this front. It has been running fiscal deficits greater than a trillion dollars every year since 2009. It makes up for this deficit by borrowing. It borrows money by selling bonds on which it pays interest.
Currently, the US government has sold bonds close to $16.69 trillion. Of this, around $4.8 trillion worth of bonds have been bought by agencies of the US government which primarily run pension funds and retirement funds. The American households own around $1.2 trillion or around 7.2% of the total outstanding bonds of $16.69 trillion.
This is not surprising given that the savings rate in America has averaged at around 4.6% of the disposable income over the last 10 years. In July 2005, it had fallen to as low as 2% of disposable income. It has since recovered and since the beginning of 2013, it has averaged at 4.4% of the disposable income. The moral of the story is that the average American doesn’t save enough to be able to lend to his government.
So who are the other lenders to the US government? As I explained in detail yesterday the Federal Reserve of United States, the American central bank, is a major lender to the government. Currently it holds bonds worth $2.086 trillion or around 12.5% of the total outstanding bonds of $16.69 trillion.
This lending has gone up by 434% over the last five years. On September 17, 2008, two days after the investment bank Lehman Brothers went bankrupt, the Federal Reserve held US government bonds worth around $479.84 billion. As stated earlier currently it holds bonds worth $2.086 trillion.
The Federal Reserve doesn’t have any money of its own. It basically prints money and uses that money to buy government bonds. This money printing adds to the money supply. This excess money can ultimately lead to high inflation with excess money chasing the same amount of goods and services.
Hence, the Federal Reserve printing money to buy US government bonds is something that cannot continue forever. In fact, Ben Bernanke, had indicated in May-June 2013, that the Federal Reserve will go slow on money printing in the months to come. Since then, he has gone back on what he had said and indicated that the money printing will continue for the time being.
But even with that change in position, the US government cannot continue to rely on the Federal Reserve to finance a significant part of its fiscal deficit by buying its bonds. As I mentioned yesterday, between 2009 and 2012, the US government ran a fiscal deficit of $5.09 trillion. During the same period the Federal Reserve’s holdings of US government bonds went up from $475.92 billion (as on December 31, 2008) to $1.67 trillion (as on January 2, 2013). This increase, amounts to roughly $1.2 trillion. This amounts to around 23.6% of the total fiscal deficit of $5.09 trillion.
So the question is who will the US government have to ultimately borrow from? The answer is other countries.
As of the end of July 2013, foreign countries held a total of $5.59 trillion of US government bonds. Of this China was at the top, having invested $1.28 trillion. Japan came in a close second, with $1.14 trillion. How has this holding changed over the years? As of September 2008, the month in which the current financial crisis started with the investment bank Lehman Brothers going bust, the foreign countries held US government bonds of $2.8 trillion. Hence, between September 2008 and July 2013, their holdings have doubled (from $2.8 trillion to $5.59 trillion).
Given this, what it clearly tells us is that the foreign countries have helped by the US government run its trillion dollar fiscal deficits by buying its bonds.
Let us look at this data a little more closely. As of the end of December 2008, the foreign countries held US government bonds of $3.07 trillion. By December 2012, this had gone up to $5.57 trillion. This meant that during the period foreign government bought bonds worth $2.5 trillion. During the period the US government ran up a fiscal deficit of $5.09 trillion. The foreign governments financed around 49% of this, by buying bonds worth $2.5 trillion($2.5 trillion expressed as a % of $5.09 trillion).
During this period, some of the bonds that foreign countries had bought would have matured. The US government spends more than what it earns. Hence, it does not have the money to repay the maturing bonds from what it earns. Given this, it needs to sell new bonds in order to repay maturing bonds. A part of these new bonds being sold over the last five years have been bought by the Federal Reserve. The Federal Reserve has done this by printing money.
Hence, the US government has paid for a part of its maturing bonds by simply printing dollars. This is similar to running a Ponzi scheme, where the government is paying off old bonds by issuing new bonds. A Ponzi scheme is essentially a financial fraud where the money that is due to older investors is repaid by raising fresh money from newer investors. The scheme keeps running till the money brought in by the new investors is greater than the money that needs to repaid to older investors. The moment this reverses, the scheme collapses.
Despite this, foreign countries have been more than happy to buy US government bonds. As we saw a little earlier in this piece, they have doubled their holding of US government bonds between September 2008 and July 2013. In short, foreign countries along with the Federal Reserve have helped the US government to keep running its Ponzi scheme.
Why is that the case? The United States with nearly 25% of the world GDP is the biggest economy in the world. By virtue of that it is also the world’s biggest market where China, Japan and countries from South East Asia and South America, sell their goods and earn dollars in the process.
The way things have been evolved, the US imports and countries like China, Japan, Saudi Arabia etc earn dollars in the process. These dollars can either be kept in the vaults of central banks of these countries or be invested somewhere.
Hence, over the years, these dollars have made their way to be invested in US government bonds, deemed to be the safest financial security in the world. With so much money chasing them, the US government, has been able to offer low rates of interest on them.
This has helped keep overall interest rates low as well. It has allowed American citizens to borrow money at low interest rates and spend it on consuming imported goods. So the Americans could buy cars from Japan, apparel and electronics from China and countries in South East Asia and oil from Saudi Arabia. And so the cycle worked. The US shopped, China and other countries earned, they invested back in the US, the US borrowed, the US spent, China and the other countries earned again and lent money again.
The way this entire arrangement evolved had the structure of a Ponzi scheme. China and other countries invested money in various kinds of American financial securities including government bonds. This has helped keep interest rates low in the US. This helped Americans consume more. The money found its way back into China (like a return on a Ponzi scheme), and was invested again in various kinds of American financial securities, helping keep interest rates low and the consumption going. Like in a Ponzi scheme, the dollars earned by China and other countries has kept coming back to the US.
Hence, foreign countries have an incentive in keeping this Ponzi scheme going. Earlier, it was important for them to keep buying US government bonds to keep interest rates low and help American consume more. It was also important to keep buying these bonds to ensure that the US government had enough money to repay them. Now it has reached a stage, where the US government is repaying them by simply printing dollars.
But even with this foreign countries are likely to continue lending money to the US government by buying its bonds. Sanjiv Sanyal, global strategist, Deutsche Bank Market Research makes this point in a recent report titled Bretton Woods III and the Global Savings Glut.
As he writes “The basic idea is that, when people are young, they have little savings and may even need to borrow in order to spend on consumption and/or build assets. However, as they grow older, their net savings rise as they build up a stock of wealth that is later run down in very old age. The same dynamic can be said to broadly hold for countries as they experience demographic transitions although there are nuances that vary according to cultural context and fiscal incentives of individual countries.”
Basically what this means is that as a country ages (with the average age of its population rising) it tends to save more. Sanyal expects many developing countries to age at a very fast pace over the next two decades. As he writes “The link is even clearer if one considers the pace of aging by comparing the current median age with the expected median age in 2030. For instance, Japan will then have a median age of 51.6 years while China will go from being significantly younger than the US in 2010 to becoming significantly older after two decades. The aging of South Korea is even faster.” He expects these countries to have a median age of 40 by 2030.
Given this, it is likely that as countries age, they will keep generating excess savings. A lot of this money is likely to find its way into the United States, feels Sanyal. As he writes “we know that lenders do not just care about high returns but about policy risk, property rights, corporate governance and the overall ability/willingness to the borrower to return the money. Thus, aging current-account surplus countries may prefer to park their funds in safer countries even though returns are higher in certain emerging markets.”
And this will help the American government to continue borrowing. It will also keep interest rates low and help Americans keep their excess consumption going. “The next round of global economic expansion may require the US to revert to its role as the ultimate sink of global demand,” writes Sanyal.
And so the Great American Ponzi scheme might just continue for a while.
The article originally appeared on www.firstpost.com on October 18, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek) 
 

Debt ceiling absurdity: US Fed will now repay itself by printing money

 
Federal-Reserve-Seal-logoVivek Kaul 
It was widely expected that the Democrats and the Republicans will finally strike a deal and extend the debt ceiling of the government of the United States(US). And that’s precisely what happened.
A few hours before the US government would have reached its debt ceiling, both the houses of the American Congress, passed a short term bill, allowing the government to suspend the debt ceiling until February 7, 2014. The Senate passed the bill, 81:18. The House of Representatives passed the bill 285:144. The bill will also end the government shut-down in the United States and allow it to operate till January 15, 2014.
Governments around the world spend more than they earn. They make up for the difference by borrowing money. The US government is no different on this front. The only trouble is that it is not allowed to borrow beyond a certain limit. This limit is referred to as the debt ceiling and till yesterday was set at $16.69 trillion.
If the bill suspending the debt ceiling had not been passed, the US government would not have been able to borrow more. And given that it would have become difficult for it to meet its expenditure from its income. Today, i.e. October 17, 2013, the US government will have around $28 billion of cash on hand. The treasury secretary Jack Lew had suggested in early October that expenditure of the US government on certain days could touch even $60 billion.
Given this, it would be able to meet only a part of its expenditure and hence, someone was not going to get paid.
The tricky question for the government would have been to decide who that someone would be. Would the government decide not to pay out the pension cheques? Or would it be unable to pay salaries of its employees? Would it default on the interest payments that are due on its bonds? Or would it be unable to repay maturing bonds? The American government like other governments around the world makes up for the difference between what it earns and what it spends, by selling bonds.
Interest payments of around $6 billion are due before the end of October. Also, bonds worth around $90-93 billion need to be repaid between October 24 and October 31. A default on this front would be catastrophic. The US government bonds (or treasuries as they are more commonly referred to as) are deemed to be the safest financial securities in the world. And if the security deemed to be the safest financial security in the world is not safe, what is?
But these are points that I have made before (you can read them here). The US government’s current debt stands at around $16.69 trillion. It has borrowed this money by selling bonds. Of this nearly $4.8 trillion is held by various agencies of the US government. Most of the US government agencies holding US government bonds are pension funds and retirement funds, which need to make payments in the years to come. To be able to make these payments, they need to invest now. Hence, they invest money in US government bonds deemed to be the safest financial security in the world.
The remaining US government debt of around $11.89 trillion ($16.69 trillion – $4.8trillion) is referred to as the debt held by the public. Of this, foreign nations hold around $5.7 trillion. China holds around $1.28 trillion and Japan $1.14 trillion.
What is interesting is that the Federal Reserve of United States, the American central bank, holds US government bonds worth $2.086 trillion. On the whole, this is only 12.5% of the total US government debt of $16.69 trillion. But what is interesting is that over the last five years the holding of the Federal Reserve has risen by 434%.
On September 17, 2008, two days after the investment bank Lehman Brothers went bankrupt, the Federal Reserve held US government bonds worth around $479.84 billion. As stated earlier currently it holds bonds worth $2.086 trillion. In comparison the debt held by foreign nations has gone up only marginally.
In the last one year, this holding has gone up by nearly $433 billion. What is happening here? The US government is spending substantially more than what it is earning. Since 2009, it has been running fiscal deficits of greater than a trillion dollars. Between 2009 and 2012 the US government ran a total fiscal deficit of $5.09 trillion. In 2013, it is expected to run a fiscal deficit of around a trillion dollars. Fiscal deficit is the difference between what a government earns and what it spends.
In a situation like this, if the US government would borrow all the money from the public, interest rates would shoot up, given that there is only so much amount of money that can be borrowed. And if the government borrows more, then there would be lesser amount of money for others(primarily the private sector) to borrow. This crowding out would lead to a situation where other institutions like banks would have had to offer a higher interest to borrow.
If a bank borrows money at a high rate of interest, it would have to lend it out at a still higher rate of interest, in order to make a profit. Higher interest rates would mean, higher EMIs. This would discourage the average American from borrowing and spending money, something which the US government believes is very important for reviving economic growth.
This is where the Federal Reserve stepped in. It has been buying the bonds being sold by the US government to finance its fiscal deficit. Where does the Federal Reserve get this money from? It simply prints it and hands it over to the government.
As we saw earlier, between 2009 and 2012, the US government has run a fiscal deficit of $5.09 trillion. During the same period the Federal Reserve’s holdings of US government bonds went up from $475.92 billion (as on December 31, 2008) to $1.67 trillion (as on January 2, 2013). This increase, amounts to roughly $1.2 trillion. This amounts to around 23.6% of the total fiscal deficit of $5.09 trillion.
Hence, the US government financed nearly 23.6% of its fiscal deficit by selling bonds to the Federal Reserve. Federal Reserve handed over this money to the US government by simply printing it. This has helped keep interest rates low in the United States.
And that is the real story. A lot of the US government borrowing over the last few years has been directly from the Federal Reserve. And now that the debt ceiling has been raised, this will continue.
The money that is borrowed by the US government from the Federal Reserve and other sources, is used to fund its expenditure. A substantial part of the expenditure is repayment of past debts as bonds mature, as well as payment of interest on these bonds.
In the year 2012, the US government paid a total interest of around $359.80 billion on its bonds. The fiscal deficit of the US government was around $1.08 trillion. Hence, nearly one third of the fiscal deficit was because of interest rate payments.
The US government does not earn enough to repay maturing bonds. Hence, it has to borrow money to repay bonds. This is a perfect Ponzi scheme where the government is paying off old debt by issuing new debt. A Ponzi scheme is essentially a financial fraud where the money that is due to older investors is repaid by raising fresh money from newer investors. The scheme keeps running till the money brought in by the new investors is greater than the money that needs to repaid to older investors. The moment this reverses, the scheme collapses.
In fact, as bonds being bought by the Federal Reserve from the US government, come up for maturity they will be repaid by getting the Federal Reserve to print money and buy new bonds. Hence, the Federal Reserve will be printing money to repay itself. If that isn’t absurd, I don’t know what is. The US Federal Reserve is currently helping the US government run its Ponzi scheme by printing money and buying bonds.
Having said that, increasing the debt ceiling was important given that even a whiff of a default would have caused a global financial crisis. First and foremost investors would have started selling out off US government bonds. This would have driven bond prices down and bond yields up, in the process pushing up interest rates first in the US and then globally. This would have put the entire plan of the US government to revive economic growth by maintaining low interest rates in a jeopardy. It would have also led to investors all over the world selling out of various financial markets. The logic would have been that if the security deemed to be the safest financial security in the world is not safe, what is?
Of course, the trouble is that the US government will breach its debt ceiling again in a few months time. What happens then? The debt ceiling has been in place in the US since 1939. Since 1960, the American Congress has increased the ceiling 79 times. So what stops it from doing it the 80th time as well? Nothing really. But till when can this Ponzi scheme go on? Ultimately all Ponzi schemes collapse. The only question is when. And for that I really do not have an answer.
The article originally appeared on www.firstpost.com on October 17, 2013 
(Vivek Kaul is a writer. He tweets @kaul_vivek)