Money printing

Central banks are now printing money to repay themselves

3D chrome Dollar symbolIn a recent report titled Debt and (not much) deleveraging the McKinsey Global Institute found that between 2007 and the second quarter of 2014, the total global debt had grown by $57 trillion. The total global debt as of the second quarter of 2014 stood at $199 trillion or 286% of the global GDP.
Government debt constituted a significant portion of this. The total government debt all around the world had stood at $33 trillion as of 2007. It has since jumped to $58 trillion, a jump of $25 trillion, at the rate of 9.3% per year.
What is interesting is that a lot of this government debt is owed to central banks. “Today, the central banks of the United States, the United Kingdom, and Japan hold 16, 24, and 22 percent, respectively, of government bonds outstanding in their countries,” the McKinsey report points out. Governments borrow money by selling bonds.
In the aftermath of the financial crisis that broke out in September 2008, central banks in developed countries started printing money. The idea was to flood the financial system with a lot of money and drive down interest rates. At lower interest rates more people were expected to borrow and spend. This would benefit businesses and in turn the overall economy.
In order to pump the printed money into the financial system the central banks bought both government as well as private sector bonds. And that is how they have ended up with massive holdings of government bonds on their balance sheets.
The central banks of the United States as well as the United Kingdom have stopped printing money and buying bonds. Nevertheless, central banks of a few other countries continue to print money and buy government bonds.
The Bank of Japan is mandated to buy 80 trillion yen worth of government bonds every year against 50 trillion yen. Starting in January 2015, the European Central Bank has also decided to buy up to €720 billion of government bonds in a year. So, in that sense central banks continue to accumulate bonds at a rapid rate.
A central bank gets paid interest by the government on the government bonds that it has in its kitty. This interest that a central bank gets paid is a part of the profit that it makes. The profit is remitted back to the government. Hence, what this means is that the government is basically paying interest to itself on its debt.
“In a sense, this debt is merely an accounting entry, representing a claim by one part of the government on another. Moreover, all interest payments on this debt typically are remitted to the national treasury, so the government is effectively paying itself,” the McKinsey report points out.
If the money that governments owe to their central banks is not taken into account, things start to look a little different. The government debt to GDP ratio in the United States falls from 89% to 67%. In the United Kingdom the number similarly falls from 92% to 63%. In case of Japan, the drop is huge—from 234% to 94%.
What these numbers also tell us is that central banks are printing money to repay themselves. How did this astonishing situation arise? Take the case of Bank of Japan. The Japanese central bank prints money and buys government bonds directly from the government. This helps the government finance its increased expenditure. A part of this expenditure is also repaying the bonds which are maturing. A part of the maturing bonds are held by Bank of Japan. Money is fungible, and hence that means that the Bank of Japan is printing money to repay itself.
This is a weird situation. As John Truman Wolfe writes in Crisis by Design, The Untold Story of the Global Financial Coup, a book published in mid-2010: “How bizarre is it that instead of simply printing the money themselves, governments ‘chose’ to borrow it from their respective central bank. The United States is currently $16 trillion in debt—and the debt is growing at the rate of $49,000 a second! Last year’s interest on the debt here was $454,000,000,000—Why borrow money from the Fed ([which] simply creates it out of thin air by making a book entry and clicking a mouse) when the government could simply print its own without borrowing it and paying interest on it.”
It is now being said that this situation can be set right given that the debt owed to central banks is ultimately an accounting entry. As the McKinsey report points out: “Whether central banks could cancel their government debt holdings is unclear… Another option that has been suggested is to replace the government debt on the central bank’s balance sheet with a zero-coupon perpetual bond.”
A perpetual bond would mean that the government will have to never repay the bond, at the same time it won’t have to pay any interest on it given the zero coupon. While this sounds fancy, this would still mean a default by the government. Governments defaulting on their debt has happened regularly in the past. “Today’s rich European nations, including England and France, defaulted repeatedly from the 14th to the 18th centuries (France did it eight times). Latin American economies defaulted repeatedly in the 20th century, and Argentina has done it once in the 21st. The most recent sovereign debt restructuring was in 2012 in Greece,” the McKinsey report points out.
And any default or a semblance of a default won’t go down well with financial markets all over the world. “Any such move could create backlash in the markets and, in some countries, by policy makers.”
A financial market backlash would mean that bond yields will go up, which in turn will push up interest rates. This is something that the governments of the Western economies can ill-afford at this point of time. Any move up in interest rates will have a negative impact on the economies, which are floundering at this point of time.
Given this, even though it is just an accounting entry, getting out of central bank debt won’t be so easy for western governments.

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

The column originally appeared on Firstpost on Apr 13, 2015

Why money printing hasn’t led to inflation Part 2

3D chrome Dollar symbolIn a column published on March 24 I had explained why despite all the money printed by the central banks of the world over the last six and a half years, we haven’t seen much conventional inflation. The central banks have printed money (or rather created it digitally through a computer entry) and used it to buy government and private bonds
By buying bonds, central banks pumped the printed money into the financial system. This was done primarily to ensure that with so much money floating around, the interest rates would continue to remain low. At low interest rates people would borrow and spend. This would help businesses grow and in turn help the moribund economies of the developed countries.
But money printing should have led to inflation as a greater amount of money chased the same amount of goods and services. Nevertheless, inflation continues to remain very low in most of the developed world.
This, as I had explained, is primarily because of the fact that the world is in midst of a balance-sheet recession (a term coined by Japanese economist Richard Koo). Between 2000 and 2007, people in the developed world had taken on huge loans to buy homes in the hope that prices would continue to go up forever.
A recent report titled Debt and (not much) deleveraging brought out by the McKinsey Global Institute explores this point in great detail. As the report points out: “Between 2000 and 2007, household debt relative to income rose by 35 percentage points in the United States, reaching 125 percent of disposable income…In the United Kingdom, household debt rose by 51 percentage points, to 150 percent of income.” Other parts of the developed world also saw similar sort of increases in their household debt.
Much of this increase in household debt came from people taking on more and more home loans (or mortgage) to buy property. “In the United States, for example, household debt grew from just 16 percent of disposable income in 1945 to 125 percent at the peak in 2007, with mortgage debt accounting for 78 percent of the growth. Mortgage debt represents the majority of household debt growth in other countries as well. Our data show that mortgages now account for 74 percent of household debt in advanced economies,” the McKinsey report points out.
What is interesting is that this increase in home loans (or mortgage debt) in particular and overall household debt in general, was not accompanied by an increase in home-ownership rates. “In the United States, for instance, the rate of homeownership rose from 67.5 percent in 2000 to 69 percent at the peak of the market in early 2007, while household debt rose from 89 percent of disposable income to 125 percent. In the United Kingdom, the homeownership rate rose by 1.3 percentage points from 2001 to 2007, while the household debt ratio rose from 106 percent of income to 150 percent,” the McKinsey report points out.
As home loans were easily available at low rates of interest, more and more money was borrowed to buy homes. This pushed up home prices in most of the developed world. Between 2000 and 2007, home prices rose by 138 percent in Spain, 108 percent in Ireland, 98% in United Kingdom, 89%in Canada and 55% in the United States (on a slightly different note, real estate prices in India during the same period would have risen at a much faster rate. But we are talking about developed economies here where home-ownership rates are high and populations are stable or declining).
As home prices went up, this meant that the newer individuals wanting to buy homes had to take on a larger amount of home loan. This pushed up total household debt.
The correlation between rising home prices and increase in household debt to income ratio is very strong across countries. What also encouraged people to take on home loans was the fact that interest rates were very low, which meant that monthly EMIs required to pay off home loans were low as well. Hence, people could borrow much more than they would otherwise have.
Also, as home prices went up, people borrowed and bought homes not to live in them, but to just speculate, hoping that prices will continue to go up forever. A survey of home buyers carried out in Los Angeles in 2005, found that the prevailing belief was that prices would keep growing at the rate of 22 percent every year over the next 10 years. This meant that a house, which cost a million dollars in 2005, would cost around $7.3 million by 2015. So strong was the belief that home prices will continue to go up.
But that wasn’t to be. Once the bubble burst, housing prices crashed. This meant the asset (i.e., homes) people had bought by taking on loans had lost value, but the value of the loans continued to remain the same. Hence, people needed to repair their individual balance sheets by increasing savings and paying back debt.
Further, many of these loans had been issued at low interest rates. Once these interest rates started to go up, the EMIs also went up. As the McKinsey report points out: “In countries where many households have variable rate mortgages [home loans], such as the United Kingdom (and more recently Denmark), households are exposed to interest rate risk. When rates rise and monthly debt service charges are adjusted upward, some households may find they cannot afford their mortgages. This occurred in the United States prior to 2007, when households took out variable-rate mortgages with low “teaser rates,” but had trouble keeping up after a few years when the teaser rates expired.”
As EMIs went up and home prices crashed, more and more income was used to service the home loans. This had an impact on consumption. As the McKinsey report points out: “This dynamic is seen clearly across US states…A similar pattern can be seen across countries: the largest increases in household debt to income ratios occurred in Ireland (125 percentage points) and Spain (59 points), which also had the largest drops in consumption.”
As the accompanying table(from the McKinsey report) shows, households in many countries have been deleveraging since 2008, after the start of the financial crisis.
What this tells us clearly is that people are using more and more of their income to pay off their existing loans. Hence, even though central banks have ensured that low interest rates continue to prevail, people are no longer interested in borrowing and spending money. They are more interested in paying off their existing loans.
And that explains why all the money printing hasn’t led to conventional inflation though there has been a lot of asset price inflation. Investors have borrowed money at low interest rates from developed countries and invested them in financial markets all over the world, leading to stock markets rallying.

The column originally appeared on The Daily Reckoning on April 2, 2015

Why money printing hasn’t led to inflation

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In response to the last column Janet Yellen’s excuses for not raising interest rates will keep coming a reader wrote in asking why all the money printing that has happened since September 2008 in the aftermath of the financial crisis, hasn’t led to inflation.
In this column I try and answer that question. Economist John Mauldin estimates that central banks have printed $7-8 trillion since the start of the financial crisis. In another estimate, author and financial derivatives expert Satyajit Das points out balance sheets of the major central banks have expanded from around $5 trillion prior to 2007–2008 to over $18 trillion.
The central banks printed this money (or rather created it digitally through a computer entry) and used it to buy government and private bonds and this has led to the expansion of their balance sheets. In fact, the amount of money pumped into the financial systems of the developing countries has been so huge that it would be suffice to purchase a large flat-screen TV for every single individual in the world, points out Das.
By buying bonds, central banks pumped the printed money into the financial system. This was done primarily to ensure that with so much money floating around, the interest rates would continue to remain low. At low interest rates people would borrow and spend. This would help businesses grow and in turn help the moribund economies of the developing countries.
But money printing should have led to inflation as a greater amount of money chased the same amount of goods and services. Milton Friedman, the most famous economist of the second half of the twentieth century, wrote in Money Mischief – Episodes in Monetary History: “The recognition that substantial inflation is always and everywhere a monetary phenomenon is only the beginning of an understanding of the cause and cure of inflation…Inflation occurs when the quantity of money rises appreciably more rapidly than output, and the more rapid the rise in the quantity of money per unit of output, the greater the rate of inflation. There is probably no other proposition in economics that is as well established as this one.”
Nevertheless that did not happen. Inflation remains very close to 0% in large parts of the developed world. Why is that the case? Japanese economist Richard Koo perhaps has an answer. Koo calls the current state of affairs in the United States as well as Europe a balance-sheet recession. Japan had seen a huge real estate as well as stock market bubble in the 1980s. In fact, such was the confidence in the high home prices continuing that by the end of the 1980s Japanese home buyers were even taking out 100-year home loans or mortgages.
As Stephen D. King writes in When the Money Runs Out: “By the end of 1980s, it was not unusual to find Japanese home buyers taking out 100-year mortgages, happy, it seems, to pass the burden on to their children and even their grandchildren. Creditors, meanwhile, naturally assumed the next generation would repay even if, in some cases, the offspring were not more than a twinkle in their parents’ eyes. Why worry? After all, land prices, it seemed, only went up.”
That did not turn out to be the case. The stock market bubble started bursting in December 1989, and the real estate bubble followed. Koo feels the current Western situation is very similar to that seen in Japan in 1990, when both the stock market bubble and the real estate bubble had burst.
What does this imply in the current scheme of things? People in the developed world had taken on huge loans to buy homes in the hope that prices would continue to go up in perpetuity. But that wasn’t to be. Once the bubble burst, housing prices crashed. This meant the asset (i.e., homes) people had bought by taking on loans had lost value, but the value of the loans continued to remain the same. Hence, people needed to repair their individual balance sheets by increasing savings and paying back debt. This act of deleveraging, or reducing debt, brought down aggregate demand and threw the economies in the developed countries into a balance-sheet recession.
A similar thing happened in Japan as well in the 1990s. In the aftermath of the bubbles bursting the Japanese carried out quantitative easing where they bought bonds in the hope of maintaining low interest rates, so that people would borrow and spend. Nevertheless, that did not happen because people were busy paying off their old loans.
A similar dynamic is at play in the developed countries at this point of time. Hence, people are not borrowing and spending at the same rate as they are expected to, because they are busy paying off old loans. As Tim Harford explains in The Undercover Economist Strikes Back: “Printing money creates inflation only if people want to spend the money right away. And perhaps they don’t.”
While, there has been no inflation in the conventional sense of the term, what the world is seeing instead is asset price inflation. A lot of the printed money has been borrowed at very low interest rates by institutional investors and has found its way into financial markets all over the world.
Other than this money briefly went into gold and then into other physical assets as well. As Gary Dugan of RBS told me in an interview sometime back: “Gold went up as much as it did in its last wave. If you look at Sotheby’s and Christie’s, in the art market, they are doing extremely well. The same is true about the property market. Places which are in the middle of a jungle in Africa, there prices have gone upto $100,000 an acre. Why? There is no communication. No power lines.”
This explains why there is no inflation but there is asset price inflation for sure. To conclude, it is important to understand something that Harford writes: “The Federal Reserve(and other central banks) spent decades … acquiring a reputation for waging a ruthless, unending war against inflation. That reputation is so powerful and so valuable that people naturally wonder whether the Federal Reserve really would encourage inflation once the slump ended. The trouble is that if people don’t believe that threat, they won’t start spending and the slump will continue.”

 

The column originally appeared on The Daily Reckoning on Mar 24, 2015

Janet Yellen is not going to takeaway the punchbowl any time soon

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Central banks are primarily in the business of sending out messages to the financial markets. In a statement released on January 28, 2015, the Federal Reserve of the United States had said: “Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy.”
In simple English what this means is that the Fed would be patient when it comes to increasing the federal funds rate, which in the aftermath of the financial crisis which started in September 2008, has been in the range of 0-0.25%. 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. This is the longest period for which the rate has remained at such low levels, in over fifty years.
In the aftermath of the financial crisis, the Federal Reserve and other central banks around the world had cut interest rates to very low levels in the hope of encouraging people to borrow and spend more, to get their moribund economies going again.
While people did borrow and spend to some extent, a lot of money was borrowed at low interest rates in the United States and other developed countries where central banks had cut rates, and it found its way into stock markets and other financial markets all over the world. This led to a massive rallies in prices of financial assets. In an era of close to zero interest rates the stock market in the United States has seen the longest bull market after the Second World War.
Given this, the stock markets in the United States and in other parts of the world have been doing well primarily because of this low interest rate scenario that prevails. With the return available from fixed income investments(like bonds and bank deposits) down to very low levels, money has found its way into the stock market.
The January 28 statement was released after a meeting of the Federal Open Market Committee(FOMC) which is mandated to decide on the federal funds rate. These meetings of the FOMC are followed very closely all over the world simply because if the Federal Reserve does decide to start raising the federal funds rate or even give a hint of it, stock markets all over the world will fall.
After the January meeting, the FOMC met again on March 17-18, 2015. In a statement that the Federal Reserve released yesterday (i.e. March 18) after the FOMC meeting, it had dropped the word “patient”. So does this mean that the Federal Reserve will start to be “impatient” when it comes to the federal funds rate?
The Federal Reserve chairperson Janet Yellen held a press conference yesterday after the two day meeting of the FOMC, in which she clarified that: “Modification of our guidance should not be interpreted to mean that we have decided on the timing of that increase. In other words, just because we removed the word “patient” from the statement doesn’t mean we are going to be impatient.”
So what Yellen was essentially saying is that even though the Fed had removed the word “patient” from its statement released yesterday, it was not going to be “impatient,” when it comes to increasing the federal funds rate in particular and interest rates in general. Welcome to the world of central bank speak.
In fact, Yellen also clarified that the FOMC won’t increase the federal funds rate when it meets next towards the end of April, next month. At the same time she said there was a chance that the FOMC might raise the federal funds rate in the meetings after April.
This statement of Yellen has led to the conclusion in certain sections of the media that the Federal Reserve will start raising interest rates June onwards, when it meets next after the April meeting. Only if things were as simple as that. Chances of the FOMC raising interest rates this year are remote. There are multiple reasons for the same.
First and foremost is the fact that inflation in the United States is well below the Federal Reserve’s preferred target of 2%. In fact, for the month of January 2015, this number was at 1.3% much below the Fed’s target of 2%. The Fed’s forecast for inflation for 2015 is between 0.6% to 0.8%. At such low inflation levels, the interest rates cannot be raised.
Inflation is down primarily because of low oil prices as well as the fact that the dollar has rallied (i.e. appreciated) against other major currencies of the world, in the process making imports cheaper for the people of United States. Lower import prices have a significant impact on inflation. The dollar has gone up in value against the yen and the euro primarily because of the money being printed by the Bank of Japan and the European Central bank. This money printing is not going to stop any time soon. As more money is printed and pumped into the financial system, interest rates are likely to remain low. At low interest rates the hope is that people will borrow and spend more and this will benefit businesses and the overall economy.
Getting back to the dollar, an appreciating currency has the same impact on the economy as higher interest rates. Higher interest rates are supposed to slowdown demand and in the process economic growth. Along similar lines when a currency appreciates, the exports of the country become expensive and this leads to a fall in exports. This slows down economic growth. Hence, in a way an appreciating dollar has already done a part of what the Fed would have done by raising interest rates.
With a lot of money printing happening in other parts of the world, chances are the dollar will continue to appreciate. Also, oil prices are likely to remain low during the course of this year, meaning low inflation in the US.
Further in December 2014, the Fed had forecast that economic growth in the US in 2015 will range between 2.6% to 3%. This has been slashed to 2.3% to 2.7%. In this scenario , it doesn’t seem likely that the Federal Reserve will raise the federal funds rate any time soon (may be not during the course of 2015).
William McChesney Martin, the longest serving Federal Reserve Chairman, once said that the job of the Fed is “to take away the punch bowl just as the party gets going.” Yellen as of now doesn’t want to spoil the party. What this means is that the stock market rallies in large parts of the world are likely to continue in the days to come.
The only thing one can say at this point of time is—Stay tuned!

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

The article originally appeared on www.firstpost.com on Mar 19,2015

Will Federal Reserve spoil the stock market party by raising interest rates?

Federal-Reserve-Seal-logo
The prospect of future company earnings are supposed to drive stock markets. But this basic theory has broken down in the aftermath of the financial crisis that started in September 2008.
Western central banks led by the Federal Reserve of the United States have printed an astonishing amount of money over the last six and a half years and some like the Bank of Japan and the European Central Bank, continue to do so. The idea was that money printing would lead to lower interest rates, and at lower interest rates banks would lend more and consumers and businesses would borrow more. This would lead to businesses and in turn, the economy doing well.
But that hasn’t turned out to be the case. As the following table clearly shows, bank loans to small and medium enterprises(SMEs) in the United States have been falling as a proportion of total loans, over the years.

The shrinking importance of SME lending

Nonetheless, lower interest rates in much of the Western world, has allowed investors to borrow money at rock bottom interest rates and invest it in stock markets all over the world.
This is why stock markets including the Indian one have rallied big time over the last few years. For this rally to continue it is important that Western central bank continue to maintain low interest rates.
The economic situation in Europe continues to remain bad, and as of now there is very little chance that central banks of Europe will go around raising interest rates any time soon. In fact, in Switzerland the short term interest rate currently is at  − 0.75%.
Japan also continues to remain in doldrums and the chances of the Bank of Japan, the Japanese central bank, raising interest rates any time soon remain minimal. This leaves the Federal Reserve of the United States, the American central bank. And this is where things get a little tricky.
The Federal Open Market Committee of the Federal Reserve which decides on the interest rate is supposed to meet today and tomorrow (i.e. March 17 and March 18). The rate of unemployment in the United States has come down significantly over the last one year. In fact, the USA Today reports that in 2014, job growth hit a 15 year high.
Typically, a fall in unemployment leads to an increase in wage growth, as employers compete to recurit employees. But that doesn’t seem to have happened in the United States. The Fortune magazine reports that the average hourly pay of an American worker has risen by just $0.03 in the last one year. This basically means that wage growth in the United States has been more or less flat over the last one year.
The overall inflation also remains much lower than the Federal Reserve’s target of 2%. The Federal Reserve’s preferred measure of inflation is personal consumption expenditures(PCE) deflator, ex food and energy. For the month of January 2015, this number was at 1.3% much below the Fed’s target of 2%.
This number falls further once the imputed(i.e. made-up data) is excluded. Before we go any further I need to explain what imputed data is. Take the case of an individual who owns the house he lives in. As the Statistics Bureau of Japan points out: “Buying a house or a piece of land is a form of property acquisition and not consumption expenditure. Such a purchase, therefore, is not counted in the CPI. Still, it is an undeniable fact that a household living in a house it owns receives some service from the house…Also, many households are paying a mortgage. Here, it leads to an issue that, one way or another, the housing expense of an owner-occupied house should be counted in the CPI calculation.”

Hence, such a situation needs to be taken into account. It is done by assuming that the “house-owning household is renting the same house from someone else.” “Then, the household has to pay some rent…An “imputed rent of an owner-occupied house” refers to the rent paid to owner-occupied houses assuming that owned house were rented. Such imputed rents are taken into the CPI calculation,” the Statistics Bureau of Japan points out.
If such data were to be excluded from inflation calculation in the United States, the results would be significantly different from the way they currently are. As Albert Edwards of Societe Generale points out in a recent research note titled Forget the ECB: A key measure of global liquidity is now in freefall, published on March 6, 2015: “We use a variant of this core PCE where the US statisticians exclude imputed (i.e. made-up) data..Five out of the last six months have registered zero inflation with only one 0.1% rise! Headline core PCE is being inflated by made-up data.”
As the fall in price of oil seeps through the system Edwards expects the inflation rate to come down to 0.3%. The other major reason for low inflation in the US is the fact that dollar has rallied majorly against all major currencies. This ensures that imports to the United States become cheaper, and thus drive down inflation.
In this scenario of almost no wage inflation and low overall inflation, will the Federal Reserve start increasing interest rates? If the Fed does not raise interest rates then foreign investors will continue raising money in dollars and investing that money in stock markets all over the world, including India.
But if the Fed does start to raise interest rates then this carry trade may run into some trouble and fresh money from foreign investors may not come into India at the same pace as it has in the past. The way things stand as of now, this remains too close to call. Nevertheless, I will stick my neck out and say, the Fed won’t raise interest rates in June this year, as it is widely expected to.
Having said that, I have my fingers crossed!

The column originally appeared on The Daily Reckoning on Mar 17, 2015