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


Vivek Kaul

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

Rajan in his speech also suggested that banks were not in the best shape as was being made out to be. As he put it The bottom line is that banks are certainly not any less risky than the past despite their better capitalization, and may well be riskier. Moreover, banks now bear only the tip of the iceberg of financial sector risks…the interbank market could freeze up, and one could well have a full-blown financial crisis.”
In the last paragraph of his speech Rajan said that “One source of concern is housing prices that are at elevated levels around the globe.” Rajan’s speech did not go down well with people at the conference. This is not what they wanted to hear.
Rajan recounts the situation in his book
Fault Lines – How Hidden Fractures Still Threaten the World Economy: “I exaggerate only a bit when I say I felt like an early Christian who had wandered into a convention of half-starved lions. As I walked away from the podium after being roundly criticized by a number of luminaries (with a few notable exceptions), I felt some unease. It was not caused by the criticism itself…Rather it was because the critics seemed to be ignoring what going on before their eyes.”
Rajan’s prediction turned out to be right in the end and a little over three years later in September 2008, the world was in the midst of a full-blown financial crisis, the impact of which is still being felt, almost six years later. Banks and financial
institutions about the go bust had to be rescued by governments all over the Western world. Also, in the aftermath of the crisis, Western governments and their central banks decided to print trillions of dollars in order to get their economies up and running again.
Now Rajan has sounded a warning again.
In an interview to the Central Banking Journal which was published a few days back Rajan said “The problems arising are not so much from credit growth, which is relatively tepid in the industrial markets and has been much stronger in emerging markets, but from asset prices due to financial risk-taking and so on. Unfortunately, a number of macroeconomists have not fully learned the lessons of the great financial crisis. They still do not pay enough attention – en passant – to the financial sector. Financial sector crises are not as predictable. The risks build up until, wham, it hits you. So it is not like economic growth, where unemployment offers a more continuous indicator.”
What Rajan is essentially saying here is that all the money printed and pumped into the financial system by the American and other Western governments has led to financial market bubbles all over the world. And these bubbles when they burst will lead to another financial crisis. As Rajan put it “We are taking a greater chance of having another crash at a time when the world is less capable of bearing the cost.”
Rajan went on to suggest that central banks have had a role to play in creating financial market bubbles all across the world. As he put it “The kind of language we hear is akin to gaming. Investors say, ‘we will stay with the trade because central banks are willing to provide easy money a
nd I can see that easy money continuing into the foreseeable future’. It’s the same old story. They add ‘I will get out before everyone else gets out’.”

In another interview to the Time magazine published on August 11, 2014, Rajan said “A number of years over which we, as central bankers, have convinced markets that we continuously come to their rescue and that we will keep rates really low for long — that we do all kinds of ways of infusing liquidity into the markets — has created markets that tend to push asset prices probably significantly beyond fundamentals, in some cases, and make markets much more vulnerable to adverse news.”
One of the reasons for the bubbles is the fact that compensation structures which encourage high financial risk-taking are back on Wall Street. The following table makes for a very interesting reading.bonus to profit ratio

Source: The Office of New York State Comptroller

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

The article was originally published on on August 14, 2014

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

Why the Federal Reserve will be back to full money printing soon

helicash Vivek Kaul 
The Federal Reserve of United States led by Chairman Ben Bernanke has decided to start tapering or go slow on its money printing operations in the days to come.
Currently the Fed prints $85 billion every month. Of this $40 billion are used to buy mortgage backed securities and $45 billion are used to buy American government bonds. Come January and the Fed will ‘taper’ these purchases by $5 billion each. It will buy mortgage backed securities worth $35 billion and $40 billion worth American government bonds, every month. The American central bank hopes to end money printing to buy bonds by sometime late next year.
The Federal Reserve started its third round of money printing(technically referred to as Quantitative Easing(QE)- 3) in September 2012. The idea, as before, was to print money and pump it into the financial system, by buying bonds. This would ensure that there would be enough money going around in the financial system, thus keeping interest rates low and encouraging people to borrow and spend money.
This spending would help businesses and in turn lead to economic growth. With businesses doing well, they would recruit more and thus the job market would improve. Higher spending would also hopefully lead to some inflation. And some inflation would ensure that people buy things now rather than postpone their consumption.
Unlike the previous rounds of money printing, the Federal Reserve had kept QE 3 more open ended. As the Federal Open Market Comittee(FOMC) of the Fed had said in a statement issued on September 13, 2012 “ If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.”
Now what did this mean in simple English? Neil Irwin translates the above statement in 
The Alchemists – Inside the Secret World of Central Bankers “We’ll keep pushing money into the system until the job market really starts to improve or inflation starts to become a problem. And we will act on whatever scale we need until we achieve that goal. We’re not going to take the foot off the gas, that is, until some time after the car has reached cruising speed. Markets had been eagerly speculating about the possibility of QE3. Instead, they got something bigger: QE infinity.”
In a statement issued on December 13, 2012, it further clarified that it was targeting an unemployment level of 6.5%, in a period of one to two years. And the hint was that once the level is achieved, the Federal Reserve would start going slow on money printing.
The unemployment rate for November 2013 came in at 7% as employers added nearly 203,000 workers during the course of the month. This is the lowest the unemployment level has been for a while, after achieving a high of 10% in October 2009. The Federal Reserve’s forecast for 2014 is that the rate of unemployment would be anywhere between 6.3 to 6.6%. Given this, it was about time that the Federal Reserve started to go slow on money printing.
History has shown us that continued money printing over a period of time inevitably leads to high inflation and the destruction of the financial system. Hence, going slow on money printing “seems” like a sensible thing to do. But there are several twists in the tail.
The unemployment rate of 7% in November 2013, does not take into account Americans who have dropped out of the workforce, because they could not find a job for a substantial period of time. It also does not take into account people who are working part time even though they have the education and experience to work full time.
Once these factors are taken into account the rate of unemployment shoots up to 13.2%. The labour participation ratio has been shrinking since the start of the finanical crisis. In 2007, 66% of Americans had a job or were looking for one. The number has since shrunk to around 63%. To cut a long story short, all is not well on the employment front.
What about inflation? The measure of inflation that the Federal Reserve likes to look at is the core personal consumption expenditure (CPE). The CPE has been constantly falling since the beginning of 2013. At the beginning of the year it stood at 2%. Since then the number has constantly been falling and for October 2013 stood at 1.11%, having fallen from 1.22% a month earlier. This is well below the Federal Reserve’s target level of 2%. In 2014, the Federal Reserve expects this to be around 1.4-1.6%. And only in 2015 does the Fed expect it touch the target of 2%.
The point is that the Federal Reserve hasn’t been able to create inflation even after all the money that it has printed over the last few years, to keep interest rates low. A possible explanation for this could be the fact that the disposable income has been falling leading to a section of people spending less, and hence, lower inflation. As Gary Dorsch, editor of Global Money Trends newsletter points out in his latest newsletter “For Middle America, real disposable income has declined. The Median household income fell to $51,404 in Feb ‘13, or -5.6% lower than in June ‘09, the month the recovery technically began. The average income of the poorest 20% of households fell -8% to levels last seen in the Reagan era.”
Given this, instead of the inflation going up, it has been falling. The benign inflation might very well be on its way to become a dangerous deflation, feels CLSA strategist Russell Napier.
Deflation is the opposite of inflation, a scenario where prices of goods and services start to fall. And since prices are falling, people postpone their consumption in the hope of getting a better deal at a lower price. This has a huge impact on businesses and hence, the broader economy, with economic growth slowing down.
Deflation also kills stock markets. As Napier wrote in a recent note “Inflation has fallen to 1.1% in the USA and 0.7% in the Eurozone and we are now perilously close to deflation…Investors are cheering the direct impact of QE on their equity valuations, but ignoring its failure to produce sufficient nominal-GDP growth to reduce debt…When US inflation fell below 1% in 1998, 2001-02 and 2008-09, equity investors saw major losses. If a similar deflation shock hits us now, those losses will be exacerbated, since the available monetary responses are much more limited than they were in the past…
We are on the eve of a deflationary shock which will likely reduce equity valuations from very high to very low levels.”
Albert Edwards of Societe Generale in a research note dated December 11, 2013, provides further information on why all is not well with the US economy. As he writes “So far, S&P 500 companies have issued negative guidance 103 times and positive guidance only 9 times. The resulting 11.4 negative to positive guidance ratio is the most negative on record by a wide marginThe highest N/P ratio prior to this quarter was Q1 2001, at 6.8…The margin cycle is turning down, profit forecasts over the next few weeks will be eviscerated. To me, this is consistent with recession.”
What these numbers tell us is that all is not well with the American economy. Over the last few years it has become very clear that the only tool that central banks have had to tackle low growth is to print more money.
Given this, it is more than likely that the Federal Reserve will go back to printing as much as it is currently doing or even more, in the days to come. The FOMC has kept this option open. As it said in a statement “However, asset purchases are not on a preset course, and the Committee’s decisions about their pace will remain contingent on the Committee’s outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchase.”
In simple English, what this means is that if the need be we will go back to doing what we were. As The Economist magazine puts it “It is entirely possible that the tapering decision will prove premature. The Fed terminated two previous rounds of QE, only to restart them when the economy faltered and deflation fears flared. The FOMC’s forecasts have repeatedly proved too optimistic. Two years ago it thought GDP would grow 3.2% in 2013; a year ago, that had dropped to 2.6%, and it now looks to come in around 2.2%..”
We haven’t seen the end of the era of easy money as yet. There is more to come.
The article originally appeared on on December 19, 2013.

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