How the Federal Reserve caused the Great Recession


This column is slightly different from the ones I usually write. On most days the idea is to write on something which is currently happening. This column doesn’t fit that formula.

In this column I wanted to write about how our world view plays a huge part in what we think and the decisions that we make, and how those decisions can turn out to be majorly wrong in the long-term, even though when we were making them they seemed to be the perfectly correct thing to do.

The dotcom bubble started to burst in early 2000. Soon after on September 11, 2011, several airliners were hijacked, of which two flew into the iconic World Trade Center in New York and one into Pentagon. The American economy which was going through tough times in the aftermath of the dotcom bubble collapsing, got into even more trouble after 9/11.

Alan Greenspan, who was the Chairman of the Federal Reserve of the United States, at that point of time, recalls in his book The Age of Turbulence that the American economy had been in a minor recession for a period of seven months before September 2001. And in the aftermath of the attacks, the reports and statistics streaming in painted a very worrying picture.

Americans had stopped spending on everything other than the items they would need in case there were more attacks. Sales of grocery items had gone up; so had sales of security devices, insurance, and bottled water. On the flip side, businesses like travel, entertainment, hotels, tourism, and even automobiles were majorly hit.

The American economy is very consumer driven and if consumers stop spending, then the economic growth immediately collapses. This was likely to happen in the months that followed September 2001.

With spending collapsing, there was a danger of the minor recession turning into a major one. To prevent this, Greenspan, as he had in the past, decided to cut interest rates. The federal funds rate, which was at 3.5 percent before the attack, was cut four times and brought down to 1.75 percent by the end of the year, starting with the first rate cut of 50 basis points, or half a percentage point, on September 17, 2001, six days days after the attack. (One basis point is one hundredth of a percentage). The federal funds rate is the interest rate at which one bank lends funds maintained at the Federal Reserve to another bank on an overnight basis. It acts as a sort of a benchmark for the interest rates that banks charge on their short and medium term loans.

Central banks cut interest rates in the hope that consumers would borrow money to spend and businesses would borrow money to expand, and so the economy would grow. As James Rickards writes in The Death of Money—The Coming Collapse of the International Monetary System: “We all asked ourselves how we could help [in the aftermath of the attack]. The only advice we got from Washington was ‘get down to Disney World … take your families and enjoy life’.”

People did borrow and spend, but they went overboard with it. America’s new bubble after dot-com was real estate and it was built on the belief that anyone could make money in real estate. As Stephen D. King puts it in When the Money Runs Out: “The white heat of the 1990s technological revolution was replaced by the stone cold of a housing boom.”

Between January 2001 and mid-2003, the federal funds rate was cut by 550 basis points to one percent. The interest rate stayed at one percent for little over a year.

The Federal Reserve did not want the United States to become another Japan. Japan had been in a low growth environment since the collapse of the stock market and the real estate bubbles, starting in late 1989. Prices had been regularly falling. In an environment of falling prices(or deflation) consumers keep postponing consumption in the hope of getting a better deal in the future. This leads to businesses suffering and the economic growth collapsing.

Ben Bernanke, who would takeover as the Chairman of the Federal Reserve from Alan Greenspan in 2006, joined the Federal Reserve in 2002 as a governor. Bernanke was a scholar on the Great Depression of 1929.

In one of the first speeches that Bernanke made after joining the Federal Reserve he said: “Whenever we read newspaper reports about Japan, where what seems to be a relatively moderate deflation—a decline in consumer prices of about 1 percent per year—has been associated with years of painfully slow growth, rising joblessness, and apparently intractable financial problems in the banking and corporate sectors … the consensus view is that deflation has been an important negative factor in the Japanese slump… I believe that the chance of significant deflation in the United States in the foreseeable future is extremely small… So, having said that deflation in the United States is highly unlikely, I would be imprudent to rule out the possibility altogether.”

This fear of not becoming another Japan and at the same time not engineering another Great Depression led to the Federal Reserve keeping interest rates low much longer than it should have. This led to the real estate bubble which would finally start bursting in 2007-2008.

As Barry Eichengreen writes in his brilliant new book Hall of Mirrors—The Great Depression, The Great Recession and The Uses—And Misuses—Of History: “With benefit of hindsight, we can say that the Fed overestimated the risk of deflation and responded too preemptively and aggressively. As a student of Japan and of the Great Depression, Bernanke may have been overly sensitive to the danger of deflation at this point of time. In other words, history may be useful for informing the views of policy makers of how to respond to certain risks, but it may also shape and inform outlooks in ways that heighten other risks”

Bernanke’s world view led to the Federal Reserve keeping interest rates low much longer than it should have. Over and above this, the inflation data that was coming out at that point of time may also have had a role to play. As Eichengreen writes: “Distorted data may have also contributed to the Fed’s exaggerated concern with deflation. Contemporaneous data showed the personal consumption expenditure deflator[the inflation index that the Federal Reserve follows], cleansed of volatile food and fuel prices, falling to less than 1% in 2003, dangerously close to negative territory. Subsequent revisions revealed that inflation in fact had already bottomed out at 1.5% and was now safely on the rise.”

This led to Federal Reserve maintaining low interest rates, when it should have been raising them. In the process, the Fed ended up fuelling the real estate bubble, which finally led to the bankruptcy of Lehman Brothers in September 2008, and the start of the current financial crisis, which was followed by what is now known as the Great Recession.

The column originally appeared on The Daily Reckoning on May 29, 2015

Japan to India: Busting the biggest myth of investing in real estate

India-Real-Estate-MarketVivek Kaul 
Japan saw the mother of all real estate bubbles in the 1980s. Banks were falling over one another to give out loans and home and land prices reached astonishingly high levels. As Paul Krugman points out in The Return of Depression Economics “Land, never cheap in crowded Japan, had become incredibly expensive: according to a widely cited factoid, the land underneath the square mile of Tokyo’s Imperial Palace was worth more than the entire state of California.”
As prices kept going up, the Japanese started to believe that the real estate boom will carry on endlessly. In fact such was the confidence in the boom that Japanese banks and financial institutions started to offer 100 year home loans and people lapped it up.
As Stephen D. King, the chief economist at HSBC, writes in his new book 
When the Money Runs Out “ By the end of the 1980s, it was not unusual to find Japanese home buyers taking out 100 year mortgages (or home loans), happy, it seems, to pass the burden on to their children and even their grand children. Creditors, meanwhile, naturally assumed the next generation would repay even if, in some cases, the offspring were no more a twinkle in their parents’ eyes. Why worry? After all, land prices, it seemed, only went up.”
Things started to change in late 1989, once the Bank of Japan, the Japanese central bank, started to raise interest rates to deflate the bubble. Land prices started to come down and there has been very little recovery till date, more than two decades later. “Since the 1989 peak…land prices have fallen by 60 per cent,” writes King.
E
very bull market has a theory behind it. Real estate bull markets whenever and wherever they happen, are typically built around one theory or myth. Economist Robert Shiller explains this myth in The Subprime Solution – How Today’s Financial Crisis Happened and What to Do about It. Huge increases in real estate prices are built around “the myth that, because of population growth and economic growth, and with limited land resources available, the price of real estate must inevitably trend strongly upward through time,” writes Shiller
And the belief in this myth gives people the confidence that real estate prices will continue to go up forever. In Japan this led to people taking on 100 year home loans, confident that there children and grandchildren will continue to repay the EMI because they would benefit in the form of significantly higher home prices.
A similar sort of confidence was seen during the American real estate bubble of the 2000s.
 In a survey of home buyers carried out in Los Angeles in 2005, the prevailing belief was that prices will keep growing at the rate of 22% every year over the next 10 years. This meant that a house which cost a million dollars in 2005 would cost around $7.3million by 2015. Such was the belief in the bubble.
India is no different on this count. A recent survey carried out by industry lobby Assocham found that “over 85 per cent of urban working class prefer to invest in real estate saying it is likely to fetch them guaranteed and higher returns.” 

This is clearly an impact of real estate prices having gone up over the last decade at a very fast rate. The confidence that real estate will continue to give high guaranteed returns comes with the belief in the myth that because population is going up, and there is only so much of land going around, real estate prices will continue to go up.
But this logic doesn’t really hold. When it comes to density of population, India is ranked 33
rd among all the countries in the world with an average of 382 people per square kilometre. Japan is ranked 38th with 337 people living per square kilometre. So as far as scarcity of land is concerned, India and Japan are more or less similarly placed. And if real estate prices could fall in Japan, even with the so called scarcity of land, they can in India as well.
Economist Ajay Shah in a recent piece in The Economic Times did some good number crunching to bust what he called the large population-shortage of land argument. As he wrote “A little arithmetic shows this is not the case. If you place 1.2 billion people in four-person homes of 1000 square feet each, and two workers of the family into office/factory space of 400 square feet, this requires roughly 1% of India’s land area assuming an FSI(floor space index) of 1. There is absolutely no shortage of land to house the great Indian population.”
The interesting thing is that large population-shortage of land is a story that real estate investors need to tell themselves. Even
 speculators need a story to justify why they are buying what they are buying.
Real estate prices have now reached astonishingly high levels. As a recent report brought out real estate consultancy firm Knight Frank points out, 29% of the homes under construction in Mumbai are priced over Rs 1 crore. In Delhi the number is at 11%. Such higher prices has led to a drop in home purchases and increasing inventory. “The inventory level has almost doubled in the last three years. In the National Capital Region, the inventory level reached 31 months at the end of March 2013 against 15 months at the end of March 2010, while in the Mumbai Metropolitan Region the inventory level has jumped from 17 months to 40 months. In Hyderabad, it reached 49 months in March 2013 as compared to 23 months in March 2010, according to data by real estate research firm Liases Foras. Inventory denotes the number of months required to clear the stock at the existing absorption rate. An efficient market maintains an inventory of eight to ten months,” a news report in the Business Standard points out.
The point is all bubble market stories work till a certain point of time. But when prices get too high common sense starts to gradually come back. In a stock market bubble when the common sense comes back the correction is instant and fast, because the market is very liquid. The same is not true about real estate, because one cannot sell a home as fast as one can sell stocks.
Real estate companies in India haven’t started cutting prices in a direct manner as yet. But there are loads of schemes and discounts on offer for anyone who is still willing to buy. As the Business Standard news report quoted earlier points out “As many as 500 projects across India are offering some scheme or the other, in a bid to push sales in an otherwise slow market. According to 
Magicbricks.com, an online property portal, Mumbai has the maximum number of projects with schemes/discounts at around 88, followed by Delhi with 56 and Chennai and Pune with 33 each. Kolkata has 30 such offers, while Hyderabad has 18 and Bangalore has 16. On a pan India level, Magicbricks has about 274 projects with discounts offer.”
Of course the big question is when will the real price cuts start? They will have to happen, sooner rather than later.
The article originally appeared on www.firstpost.com on July 2, 2013

(Vivek Kaul is a writer. He tweets @kaul_vivek)
 
 
 
 

Europe and US may have caught the Japanese disease

deflationVivek Kaul  
Before things get better, they get worse.
The Federal Reserve of United States has been on a money printing spree over the last few years. Currently it prints $85 billion every month. This money it uses to buy bonds from banks and financial institutions and thus puts ‘new’ money into the financial system.
The hope and the economic theory behind this is that banks will lend this new money to ‘prospective’ borrowers, who will spend it to buy things ranging from homes to cars to consumer goods. This in turn will revive the stagnating American economy.
The money that the Federal Reserve puts into the financial system every month also ensures that there is enough money floating around, and thus interest rates continue to remain low. People are more likely to borrow and spend money at low interest rates than high.
The money printing will also create some inflation, the hope is. As this ‘new’ money chases the same amount of goods and services, prices will start to rise at a reasonably fast rate. In a scenario where prices are rising or are expected to rise, people are more likely to buy goods and services, rather than postpone their purchases.
All this buying will give a fillip to businesses and that in turn will help the overall economy grow faster. And this is how things will get better.
As things stand as of now, this economic theory doesn’t seem to be working, dashing all hopes. In fact, inflation instead of going up, has been falling in the United States. The Federal Reserve’s preferred measure of inflation is the personal consumption expenditure (PCE) deflater. This for the month of March stood at 1.1%, having fallen from 1.3% in February. The number stood 1.92% in March 2012.
What this tells is that the rate at which the personal consumption expenditure is growing has been coming down over the last one year.
A similar situation seems to be prevailing in Europe as well. As Ambrose Evans Pritchard recently 
wrote in a column in The Daily Telegraph “The region’s core inflation rate – which strips out food and energy – fell to 1% in March. This is far below expectations and leaves monetary union with a diminishing safety buffer.”
What this tells us is that attempts by the Federal Reserve and the European Central Bank, to get inflation and consumption going by keeping interest rates low, haven’t yielded the results that had been hoped for. People are not interested in borrowing and buying things even though interest rates are at very low levels.
In fact now there is an inherent danger of inflation getting into negative territory or what economists calls deflation. “Over the last 15 years most investors have refused to contemplate that events in the West are playing out in a similar fashion to Japan in the 1990s. But the latest inflation data out of both the US and eurozone should ram home the fact that we are now only one short recession away from Japanese-style outright deflation,” writes Albert Edwards of Societe Generale in a report released on May 2, 2013.
“The eurozone is tracking the experience in Japan in mid-1990s. there is a very high risk of a slide into deflation,” said Lars Christensen, a monetary theorist at Danske Bank, told Evans Pritchard.
Japan had experienced a huge real estate bubble and a stock market bubble in the mid to late 1980s. After these bubbles cracked, the country experienced a deflationary scenario, where prices were falling. The falling prices had a huge impact on economic growth. When prices are falling, or expected to fall, people tend to postpone purchase of goods and services, in the hope of getting a better deal. This means lower revenues and hence lower profits for businesses. It also leads to slower economic growth.
Such an economic scenario is now expected to hit both the United States as well as Europe.
In fact some of this has already started to play out. As 
a newsreport in the USA Today points out “The reports also show evidence of an economy weakening — a hiring pullback, a drop in construction spending and slowing manufacturing growth, among others.” So the American economy already seems to be entering the slowdown mode.
Suggestions have been made in the recent past that the Federal Reserve will wind down its money printing in the days to come. As Patrick Legland and Dr Michael Haigh of Societe Generale pointed out in a report titled 
The End of the Gold Era released around one month back “the Fed’s balance sheet will continue to expand at $85bn/month through September, at which point purchases may be tapered modestly to $65bn/month until being fully terminated at the end of the year.”
But with a deflationary scenario looming that doesn’t seem to be a distinct possibility. The Federal Reserve hinted at this in a statement released on May 1 where it said “To support a stronger economic recovery and to help ensure that inflation, over time…the Committee decided to continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month.”
What this tells us is that the Federal Reserve plans to continue printing money and use it to buy $85 billion worth of bonds (mortgage bonds worth $40 billion and American government bonds worth $45 billion) every month. As Edwards puts it “With inflation now 
massively undershooting the Fed’s own 2-2½% target range there is nothing to stop the Fed keeping their foot pressed down hard on the gas pedal.”
As pointed out earlier the hope is that money printing will lead to some inflation and that in turn will get people to start consuming and drive economic growth. If it doesn’t there will be trouble. As the 
USA Today points out “if consumers and businesses are convinced prices of goods and services are falling, they tend to delay spending if possible. They want to wait and get the lowest price they can. That sentiment would snuff out the bull market, likely in an alarming sell-off.” And once deflation sets in, it becomes very difficult to break out of it, as has been proved in Japan’s case.
The trouble of course is that like has been the case in the past, this new money may not reach the people it is intended for, simply because they are no longer interested in borrowing and consuming.
Instead this money will be used for speculation. 
As economist Bill Bonner wrote in a recent column “The Fed creates new money (not more wealth… just new money). This new money goes into the banking system, pretending to have the same value as the money that people worked for. And people with good connections to the banks take advantage of the cheap credit this new money creates to aid financial speculation.”
The difference will be that instead of the money going into the stock market this time around it will go into bonds. As Edwards puts it “Quantitative easing (a sophisticated name for money printing) seems, in large 
part, to be bypassing the real economy, liquidity will evaporate from equities if we dive into a deflationary recession. Where will all the liquidity then go as quantitative easing is ramped up still further? It will go into ridiculously expensive bonds.”
But that doesn’t make bonds a safe investment bet. The American government is largely broke and not in a position to repay these bonds. “We remain of the view that on a 3-5 year time horizon bonds will prove to be a toxic investment and rapid inflation is the likely longer term outcome,” writes Edwards.
As the old Chinese curse goes “may you live in interesting times”. These surely are interesting times. 

The article originally appeared on www.firstpost.com  
Vivek Kaul is a writer. He tweets @kaul_vivek
 
 

Reform by stealth, the original sin of 1991, has come back to haunt us


India badly needs a second generation of economic reforms in the days and months to come. But that doesn’t seem to be happening. “What makes reforms more difficult now is what I call the original sin of 1991. What happened from 1991 and thereon was reform by stealth. There was never an attempt made to sort of articulate to the Indian voter why are we doing this? What is the sort of the intellectual or the real rationale for this? Why is it that we must open up?” says Vivek Dehejia an economics professor at Carleton University in Ottawa,Canada. He is also a regular economic commentator on India for the New York Times India Ink. In this interview he speaks to Vivek Kaul.
How do you see overall Indian economy right now?
The way I would put it Vivek is, if I take a long term view, a generational view, I am pretty optimistic. The fundamentals of savings and investments are strong.
What about a more short term view?
If you take a shorter view of between six months to a year or even two years ahead, then everything that we have been reading about in the news is worrisome. The foreign direct investment is drying up. The savings rate seems to have been dropping. The economic growth we know has dropped. The next fiscal year we would lucky if we get 6.5% economic growth.
How do we account for the failure of this particular government to deliver sort of crucially needed second generation economic reforms?
The India story is a glass half empty or a glass half full. If you look at the media’s treatment of the India story, particularly international media they tend to overshoot. So two years ago we were being overhyped. I remember that the Economist had a famous cover where they said that India will overtake China’s growth rate in the next couple of years. They made that bold prediction. And then about a year later they were saying that India is a disaster. What has happened to the India story? The international media tends to overshoot. And then they overdo it in the negative direction as well. A balanced view would say that original hype was excessive. We cannot do nor would we want to do what China is doing. With our democratic system, our pluralistic democracy, the India that we have, we cannot marshal resources like the way the Chinese do, or like the way Singapore did.
Could you discuss that in detail?
If you take a step back, historically, many of the East Asian growth miracles, the Latin American growth miracles, were done under brutal dictatorial regimes. I mean whether it was Pinochet’s Chile, whether it was Taiwan or Singapore or Hong Kong, they all did it under authoritarian regimes. So the India story is unique. We are the only large emerging economy to have emerged as a fully fledged democracy the moment we were born as a post colonial state and that is an incredibly daring thing to do. At the time when the Constituent Assembly was figuring out what are we going to do now post independence a lot of conservative voices were saying don’t go in for full fledged democracy where every person man or a woman gets a vote because you will descend down into pluralism and identity based politics and so on. Of course to some extent it’s true. A country with a large number of poor people which is a fully fledged democracy, the centre of gravity politically is going to be towards redistribution and not towards growth. So any government has to reckon with the fact that where are your votes. In other words the market for votes and the market for economic reform do not always correlate.
You talk about authoritarian regimes and growth going together…
This is one of the oldest debates in social sciences. It is a very unsettled and a very controversial one. For any theory you can give on one side of it there is an equally compelling argument on the other side. So the orthodox view in political science particularly more than economics was put forward by Samuel Huntington. The view was that you need to have some sort of political control, you cannot have a free for all, and get marshalling of resources and savings rate and investment rate, that high growth demands.
So Huntington was supportive of the Chinese model of growth?
Yes. Huntington famously was supportive of the Chinese model and suggested that was what you had to do at an early stage of economic development. But there are equally compelling arguments on the other side as well. The idea is that democracy gives a safety valve for a discontent or unhappiness or for popular expression to disapproval of whatever the government or the regime in power is doing. We read about the growing number of mysterious incidents in China where you can infer that people are rioting. But we are not exactly sure because the Chinese system also does not allow for a free media. Also let’s not forget that China has had growing inequalities of income and growth, and massive corruption scandals. The point being that China too for its much wanted economic efficiency also has kinds of problems which are not much different from the once we face.
That’s an interesting point you make…
Here again another theory or another idea which can help us interpret what is going on. When you have a period of rapid economic growth and structural transformation of an economy, you are almost invariably going to have massive corruption. It is almost impossible to imagine that you have this huge amount of growth taking place in a relatively weak regulatory environment where there isn’t going to be an opportunity for corruption. It doesn’t mean that it is okay or it doesn’t mean that one condones it, but if you look throughout history it’s always been the case that in the first phase of rapid growth and rapid transformation there has been corruption, rising inequalities and so on.
Can you give us an example?
The famous example is the so called American gilded age. In the United States after the end of the Civil War (in the 1860s) came the era of the Robber Barons. These people who are now household names the Vanderbilts, the Rockefellers, the Carnegies, the Mellons, were basically Robber Barons. They were called that of course because how they operated was pretty shady even according to the rules of that time.
Why are the second generation of reforms not happening?
What makes reforms more difficult now is what I call the original sin of 1991. We had a first phase of the economic reforms in 1991 where we swept away the worst excesses of the license permit raj. We opened up the product markets. But what happened from 1991 and thereon was reform by stealth. Reform by the stroke of the pen reform and reform in a mode of crisis, where there was never an attempt made to sort of articulate to the Indian voter why are we doing this? What is the sort of the intellectual or the real rationale for this? Why is it that we must open up? It wasn’t good enough to say that look we are in a crisis. Our gold reserves have been mortgaged. Our foreign exchange reserves are dwindling. Again India’s is hardly unique on this. Wherever you look whether it is Latin America or Eastern Europe, it generally takes an economic crisis to usher in a period of major economic reform.
So the original sin is still haunting us?
The original sin has come back to haunt us because the intellectual basis of further reform is not even on anyone’s agenda. Discussions and debates on reform are more focused on issues like the FDI is falling, the rupee is falling, the current account deficit is going up etc. Those are all symptoms of a problem. The two bursts of reform that we had first were first under Rao/Manmohan Singh and then under NDA. If a case had been made to build a constituency for economic reform, then I think we would have been in a different political economy than we are now. But the fact that didn’t happen and things were going well, the economy was growing, that led to a situation where everybody said let’s carry on. But now we don’t have that luxury. Now whichever government whoever comes to power in 2014 is going to have to make some tough decisions that their electoral base, isn’t going to like necessarily. So how are they going to make their case?
So are you suggesting that the next generation of reforms in India will happen only if there is an economic crisis?
I don’t want to say that. Again that could be one interpretation from the arguments I am making of the history. It will require a change in the political equilibrium and certainly a crisis is one thing that can do that. But a more benign way the same thing can happen that without a crisis is the realization of the political actors that look I can make economic reform and economic growth electorally a winning policy for me. But India is a land of so many paradoxes. A norm of the democratic political theory in the rich countries i.e. the US, Canada, Great Britain etc, is that other things being equal, the richer you are, the more educated you are, the more likely you are to vote. In India it is the opposite. The urban middle class is the more disengaged politically. They feel cynical. They feel powerless. Until they become more politically engaged that change in the equilibrium cannot happen.
What about the rural voter?
The rural voter at least in the short run might benefit from a NREGA and will say that you are giving me money and I will keep voting for you. We have all heard people say they are uneducated and they are ignorant, no it’s not like that. He is in a very liquidity constrained situation. He is looking to the next crop, the next harvest, the next I got to pay my bills. If someone gave him 100 days of employment and gives him a subsidy, he will take it.
How do explain the dichotomy between Manmohan Singh’s so called reformist credentials and his failure to carry out economic reforms?
One of the misconceptions that crops up when we look at poor economic performance or failure to carry out economic reform is what cognitive psychologists call fundamental attribution bias. Fundamentally attribution bias says that we are more likely to attribute to the other person a subjective basis for their behaviour and tend to neglect the situational factors. Looking at our own actions we look more at the situational factors and less at the idiosyncratic individual subjective factors. So what am I trying to say? What I am saying is that it has become almost a refrain to say that Dr Manmohan Singh should be an economic reformer. He was at least the instrument if not the architect of the 1991 reforms. There are speculations being in made in what you can call the Delhi and Mumbai cocktail party circuit, about whether he is really a reformer? Was it Narsimha Rao who was really the real architect of the reform? Is he a frustrated reformer? What does he really want to do? What’s going on his head? That in my view is a fundamental attribution bias because we are attributing to him or whoever is around him a subjective basis for the inaction and the policy paralysis of the government.
So the government more than the individual at the helm of it is to be blamed?
Traditionally the electoral base of the Congress party has been the rural voter, the minority voters and so on, people who are at the lower end of the economic spectrum. So they are the beneficiaries just roughly speaking of the redistributive policies. Political scientists have a fancy name for it. They call it the median voter theorem. What does it mean? It means that all political parties will tend to gravitate towards the preferred policy of the guy in the middle, the median voter.
Was Narsimha Rao who was really the real architect of the reform?
Narsimha Rao must be given a lot of credit for taking what was then a very bold decision. He was at the top of a very weak government as you know. And he gave the political backing to Manmohan Singh to push this first wave of reforms more than that would have been necessary just to avert a foreign exchange crisis. And then he paid a price for it electorally in the next election. This again the intangible element in the political economy that short of a crisis it often takes someone of stature to really take that long term generation view. IT means that you are not just looking at narrow electoral calculus but you are looking beyond the next election. That’s what seems to be missing right now. Among all the political parties right now, one doesn’t seem to see that vision of look at this is where we want to be in a generation and here is our roadmap of how we are going to get there.
Going back to Manmohan Singh you called him an overachiever recently, after the Time magazine called him an “underachiever”. What was the logic there?
The traditional view and certainly that was widely in the West at least till very recently has been that it was Manmohan Singh who was the architect of the India’s economic reforms. But then how do you explain the inaction in the last five, six, seven years? The revisionist perspective would say no in fact the real reformer was Narsimha Rao to begin with. The real political weight behind the reform was his. And Manmohan Singh that any good technocratic economist should have been able to do which is to implement a series of reforms that we all knew about. My teacher Jagdish Bhagwati had been writing about it for years. In that sense maybe Manmohan Singh was given too much credit in the first instance for implementing a set of reforms. If you look at his career since then he has never really been a politically savvy actor. We have this peculiar situation in India since 2004 where the Prime Minister sits in the Rajya Sabha, the upper house. That kind of thing is not barred by our constitution but I don’t think that the framers of the constitution envisaged this would be a long term situation. It is a little like the British prime minister sitting in the House of Lords. I mean that practice disappeared in the nineteenth century. He has not shown from the evidence that we can see any ability to get a political base of his own to be a counterweight to the more redistributive tendencies of the Nehru Gandhi dynasty. And that’s the sense that in somewhat cheeky way I was using the term overachiever.
Do you think he is just keeping the seat warm for Rahul Gandhi?
It increasingly appears to be that way. If that is true then it suggests that we shouldn’t really expect much to happen in the next two years.
Does the fiscal deficit of India worry you?
If you look at some shorter to medium term challenges, then things like fiscal deficit and the current account deficit are things to worry about. Again other things like the weak rupee, the weak FDI data, things that people tend to fixate at, but those at best are symptoms of a deeper structural problem. The deeper concern is the kind of reform that will require a major legislative agenda such as labour law reform for example to unlock our manufacturing sector. And managing the huge demographic dividend that we are going to get in the form of 300-400 million young people. They will have to be educated.
But is there a demographic dividend?
That’s the question. Will it become a demographic nightmare? Can you imagine the social chaos if you have all these kids just wandering around, not educated enough to get a job, what are they going to do? It’s a recipe for social disaster. That according to me is going to be real litmus test. If we are able to navigate that then I don’t see why we won’t be on track to again go back to 8- 9% economic growth. I want to remain optimistic at the end of the day.
(The interview originally appeared in the Daily News and Analysis on August 6,2012. http://www.dnaindia.com/money/interview_reform-by-stealth-the-originalsin-of-1991-has-come-back-to-haunt-us_1724348)
(Interviewer Kaul is a writer and can be reached at [email protected])

Yesterday, once more! Is the world economy going the Japan way?

Vivek Kaul

High risk means high returns.
Or does it?
Not always.
When more risk does not mean more return
The ten year bond issued by the United States (US) government currently gives a return of around 1.8% per year. Bonds are financial securities issued by governments to finance their fiscal deficits i.e. the difference between what they earn and what they spend.
Returns on similar bonds issued by the government of United Kingdom (UK) are at1.9% per year.
Nearly five years back in July 2007 before the start of the financial crisis the return on the US bonds was at 5.1% per year. The return on British bonds was at 5.5% per year.
The return on German bonds back then was around 4.6% per year. Now it stands at 1.44% per year.
Since the start of the financial crisis governments all over the world have been running huge fiscal deficits in order to try and create some economic growth. They have been financing these deficits through increasing borrowing.
In 2007, the deficit of the US government stood at $160billon. This difference was met through borrowing. The accumulated debt of the US government at that point of time was $5.035trillion.
In 2012, the deficit of the US government is expected to be at $1.327trillion or around 8.3times more than the deficit in 2007. The accumulated debt of the US government is also around three times more now and has crossed $14trillion.
The situation in the United Kingdom is similar. In 2007 the fiscal deficit was at £9.7billion. The projected deficit for 2012 is around 9.3times more at £90billion. The government debt as a percentage of gross domestic product (GDP) has gone up from around 37% of GDP to around 67% of GDP.
The same trend seems to be happening throughout the countries of Western Europe as well. Hence we can conclude that it is more risky to lend to the governments of United States, United Kingdom and countries like Germany and France in Western Europe. Though to give Germany the due credit it doesn’t run fiscal deficits as large as US or UK for that matter. Its fiscal deficit in 2010 had stood at €100billion but was cut to around €25.8billion in 2011.
Even though the riskiness of lending to these countries has gone up, the investors have been demanding lower returns from the governments of these countries. Why is that?
The answer might very well lie in what happened in Japan in the late 1980s.
The Japan story
The Japanese central bank started running a low interest policy to help exports from the mid 1980s. This other than helping exports fuelled massive bubbles in both the stock market as well as the real estate market. The Nikkei 225, Japan’s premier stock market index, returned 237% from the start of 1985 to December 29,1989, the day it peaked at a level of 38,916 points. The real estate prices also shot through the roof. As Paul Krugman points out in The Return of Depression Economics “Land, never cheap in crowded Japan, had become incredibly expensive…the land underneath the square mile of Tokyo’s Imperial Palace was worth more than the entire state of California.”
This was the mother of all bubbles.
Yasushi Mieno took over as the 26th governor of the Bank of Japan, the Japanese central bank, on December 17, 1989. Eight days later on December 25, 1989, he shocked the market by raising the interest rate. And more than that, he publicly declared that he wanted the land prices to fall by 20%, which he later upped to 30%. Mieno didn’t stop and kept raising interest rates.
The stock market crashed. And by October 1990 it was down nearly 40%. Since then the stock market has largely been on its way down. And it currently quotes at 8,900 points down 77% from the peak.
The real estate prices also fell but not at the same fast rate as the stock market. As Ruchir Sharma writes in Breakout Nations – In Pursuit of the Next Economic Miracle “ “The greatest bubble in human history” burst in 1990 with no pain at all, like falling off Everest without breaking a bone. At its peak Japan accounted for 40 percent of the property value of the planet, but instead of collapsing, the price of real estate slowly declined at a 7% annual rate for two decades, ultimately falling by a total of about 80%. There was never a major round of foreclosures or bankruptcies, as the government kept bailing out debtors, ruining its own finances.”
The GDP growth rate collapsed from 3.32% in 1991 to -0.14% in 1999. In the next ten years i.e. between 2000 and 2009, the GDP growth rate never went beyond 2.74% and was at -5.37% in 2009.
The balance sheet depression
Japan has been in what economist Richard Koo calls a balance sheet recession. What this means in simple English is that after bubbles burst, specially real estate bubbles, the private sector companies as well as individuals and families who had speculated on the bubble end up with a lot of excessive debt and an asset (like land or stocks) which is losing value. The excessive debt has to repaid. Given this individuals and companies try to save, in order to repay the debt. But what is good for the individual is not always good for the overall economy.
The paradox of thrift
John Maynard Keynes unarguably the greatest economist of the twentieth century called this the paradox of thrift. What Keynes said was that when it comes to thrift or saving, the economics of an individual differs from the economics of the system as a whole.
If one person saves more then saving makes tremendous sense for him. But as more and more people start doing the same thing there is a problem. This is primarily because what is expenditure for one person is an income for someone else. Hence, when everybody spends less, businesses see a fall in revenue. This means lower aggregate demand and hence slower or even no growth for the overall economy.
The Japanese savings rate at the time when the bubble popped was around 0%. After this the Japanese started to save more and the savings rate of the Japanese private sector and households increased. It reached around 16% of the GDP in the year 2000.
All this money was being used to pay off the excess debt that had been accumulated. This meant slower growth for Japan. The government in turn tried to pump economic growth by spending more and more money. For this it took on more debt and now the Japanese government debt to GDP ratio is around 240%.
Ironically as the government debt went up the return on the government debt kept coming down. As Martin Wolf of Financial Times points out in a recent column “At the end of 1990, when its “bubble economy” went pop, the Japanese government’s 10-year bond was yielding 6.7 per cent…But yields on 10-year Japanese government bonds (JGBs) fell to close to 2 per cent in 1997 and then, with sizeable fluctuations, to troughs of 0.8 per cent in 1998, 0.4 per cent in 2003 and, recently, to 0.9 per cent. In short, the worse the Japanese government’s present and prospective debt position has become, the lower the interest rates on JGBs has also become.” (All returns per year)
The reason for this in retrospect is very straightforward. As the Japanese individuals and companies were saving more they did not want to risk their savings in either the stock market which had been continuously falling or the real estate market which was also falling, though at a slower rate. Hence a major part of the savings went into JGBs which they thought were safer. Given that there was great demand for JGBs the Japanese government could get away with offering lower returns on its bonds, even though over the years they became riskier.
The Japan Way
Richard Koo believes that what happened in Japan over the last twenty years is now happening in the US, UK and parts of Europe. Individuals in these countries are saving more to pay off their excess debts. An average American in the month of March 2012 saved 3.8% of his disposable income in March 2012. Before the crisis the American savings rate had become negative. . The same stands true for Great Britain where savings of household were -3% at the time the crisis struck. They have since gone up to 3% of GDP. The corporate sector was saving 3% of GDP is now saving 5% of GDP. Same stands true for Spain, Ireland and Portugal where savings were in negative territory (i.e. the people were borrowing and spending) before the crisis struck, and are now going up. In the case of Ireland the savings have gone up from -10% of GDP to around 5% of the GDP since the crisis struck.
Hence companies and individuals across countries are saving more to pay off the excess debt they had accumulated. This in turn has meant that they are spending lesser money than they used to. This has led to slower economic growth. A large part of these savings is going into government bonds keeping returns low. Retail investors have taken out nearly $260billion out of equity mutual funds in the United States since 2008, even though the stock market has doubled in the last three years. At the same time they have invested nearly $800billion in bond funds, which give very low returns.
ZIRP – Zero interest rate policy
The governments of these countries have cut interest rates to almost 0% levels and are also borrowing and spending more money. That as was the case in Japan has resulted in some economic growth, but nowhere as much as they had expected. Even though governments want their citizens and companies to borrow and spend money in order to revive economic growth, they are in no mood to do that.
The citizens would rather pay off their existing debt than take on new debt. And the companies need to feel that the economic opportunity is good enough to invest, which it clearly isn’t. That explains to a large level why US companies are sitting on more than $2trillion of cash.
The banks are also not willing to take on the risk of lending at such low interest rates, as was the case in Japan. What has also not helped is the case of continuously bailing out the financial sector like was the case in Japan. Hence real estate prices in countries like Spain still need to fall by 35% to come back at normal levels.
Slow growth
All in all most of the Western world is headed towards the Japan way, which means slow economic growth in the years to come. As Sharma writes “Over the next decade, growth in the United States, Europe and Japan is likely to slow…owing to the large debt overhang”. This will impact exports out of countries like China, South Korea, Japan, Taiwan, India etc. The Chinese exports for the month of April 2012 grew at 4.9% in comparison to 8.9% during the same period last year. This in turn has pushed down imports. Imports grew at a negligible 0.33% against the expected 11%.
A slowdown in Chinese imports immediately means lower prices for commodities. As Sharma puts it “It’s my conviction that the China-commodity connection will fall apart soon. China has been devouring raw materials at a rate way out of line with the size of its economy… Since 1990, China’s share of global demand for commodities ranging from aluminum to zinc has skyrockected from the low single digits to 40,50,60 % – even though China accounts for only 10% of total global output.” .
Over a longer term slower growth in the Western World will also means slower and lower stock markets. As the old Chinese curse goes “may you live in interesting times”. The interesting times are upon us.
(This post originally appeared on Firstpost.com on May 17,2012. http://www.firstpost.com/economy/japan-disease-is-spreading-high-risk-and-low-returns-311952.html)
(Vivek Kaul is a writer and can be reached at [email protected])