Tim Harford is a senior columnist for the Financial Times. His long-running column, “The Undercover Economist”, reveals the economic ideas behind everyday experiences. Tim’s first book, “The Undercover Economist” has sold one million copies worldwide in almost 30 languages. He is also the author of “The Logic of Life“, “Dear Undercover Economist”, “Adapt” and most recently “The Undercover Economist Strikes Back.” In this free-wheeling interview to Forbes India, Tim discusses the ideas he explores in his latest book The Undercover Economist Strikes Back, from why he feels that stimulus packages to revive the sagging economies in the Western world have been far too small to why money does buy happiness to why Henry Ford was the man who invented unemployment.
One of the most interesting parts of your book is where you talk about the baby sitting recession. What is that all about?
The babysitting recession was first discussed in an article published by Joan and Richard Sweeney in the 1970s, but it has been made famous by Paul Krugman. There was a babysitting co-op in Capitol Hill, Washington DC, that suffered a severe and lasting depression. Couples would keep track of who was babysitting for whom by exchanging babysitting tokens; however, there weren’t enough tokens in the economy. Almost everybody wanted to babysit for other people, accumulating a few more tokens, as a reserve, before they spent any tokens themselves. But of course the arithmetic does not work: somebody has to go out or this no economy at all.
So what drew you this example?
A number of things are interesting about this example – notably that a total economic breakdown could be fixed by a simple policy tweak: printing more tokens. (Paul Krugman has more recently tended not to mention the end of the story: the co-op printed too many tokens and ended up suffering from a serious inflation problem. But that is more of an interesting sting in the tale than a refutation of the entire example.) In The Undercover Economist Strikes Back I use the babysitting recession as a nice simple example of a Keynesian recession; in a Keynesian recession there is some dysfunction in the way the economy works, a dysfunction that can be fixed by governments printing money or perhaps borrowing and spending money. Some commentators believe Keynesian recessions are logically impossible; this is nonsense and it is nice to have a simple counter-example.
Another interesting part is about the prison camp recession. What is that all about?
The prison-camp I talk about was in Germany during the Second World War. The economic activity in the camp – a bit of production, but mostly trading items sent to prisoners by the Red Cross – was analysed in a quite brilliant article by one of the prisoners, Robert Radford, who published his findings a few months after the war ended.
And what did Radford find?
The prison camp is almost the perfect counter-weight to the baby-sitting co-op. Trade in the prison camp worked amazingly well. There were well-understood prices and middlemen ensuring that prices in different parts of the camp tended to converge to similar levels. At one stage, coffee was worth more outside the camp in the cafes of Munich than it was inside the camp, that meant gains from trade, and coffee began to go “over the wall” – the prison camp had an export trade! Despite various attempts from the senior officers to regulate trade and particularly to fix prices at levels they regarded as fair, prices were flexible and refused to respect any social or ethical conceptions of the “just price”. This was close to a perfect market. And yet… and yet the prisoners nearly starved to death.
Oh, why was that?
Why they starved is not hard to understand. The parcels from the Red Cross began to dry up as the war progressed. Food and cigarettes both became scarce. In the last, desperate days, there were few goods and prices fluctuated wildly. Finally the US Army arrived and liberated the prisoners.
But what does all this have to do with a modern economy?
The point is that there are two conceptions of what a recession really is. One conception is Keynesian, like the babysitting co-op: some internal malfunction that needs fixing. But another conception is Classical: that economies fluctuate not because of anything wrong within the economic system itself, but because of policy errors or external shocks. Of course the prison camp is an extreme example of a recession caused by an external shock, but modern economies are subject to technological changes, fluctuations in the price of basic commodities, and of course financial shocks from a banking crisis.
Where do the baby sitting recession and the prison camp recession meet? What are the policy lessons one can draw from them?
A Keynesian, baby-sitting co-op recession invites a role for government intervention – most famously through fiscal policy (cutting taxes or boosting spending) but also through monetary policy (cutting interest rates or even printing new money). A Classical, prison-camp recession invites a more fatalistic response: there’s nothing the government can do to make things better, and plenty of things it can do to make things worse. The huge argument that has raged in many economies about fiscal stimulus versus austerity is really a debate about whether recent recessions have been mostly Keynesian, or mostly Classical. If Classical, then austerity is the right response: we’re poorer and we need to get used to it. If Keynesian, then fiscal stimulus is the right response: we’re only poorer if the government gives up and allows us to be!
So are the recent recessions Keynesian or Classical?
In a book you can give black-and-white examples and in life, nothing is black and white. But in my view the recent recessions have been at least partially Keynesian and governments – especially in the UK and US, where they had a choice – should have postponed austerity measures.
The western world has been running stimulus programmes. Do they really work?
It’s interesting that this is your perception. I think most stimulus packages have been far too small – although the US has at least tried. The evidence on such things is always tricky because macroeconomists (unlike microeconomists) cannot run controlled trials. But we can try our best.
Can you elaborate on that?
The International Monetary Fund at first estimated a modest effect from fiscal stimulus – that is, government spending does make the economy larger in the short run, but only a bit. But the Fund later recanted and argued that in the recent recession, fiscal stimulus was far more effective than they’d believed at first.
Let’s assume this is correct (I think it is). How did the Fund make their original mistake? The problem was that they were looking at historical evidence on stimulus spending, and the historical evidence incorporated much milder recessions in which monetary policy was a good alternative to fiscal stimulus. Those mild recessions weren’t a good guide to recent experience, alas.
What is the best way to make a stimulus work?
As for how to make stimulus work, I argue in my book that the best bet is advanced planning: governments should have a list of well-planned infrastructure projects, and should accelerate those plans in case of a downturn. That way, we carry out the investment we were intending to anyway, but at a time when it will have nice macroeconomic side-effects.
Economists have been criticised for having too much faith in GDP growth. Even Simon Kuznets, the man who invented GDP never saw it as a measure of welfare. You write that “they rely on the popular misconception that much of what is wrong with the way the economy is organised is wrong because we collect GDP statistics, and that the way to fix our economic problems is to measure something else. I think that is a mistake”. Why is that a mistake?
Because it isn’t the measuring of GDP that has caused the problems. We had economic growth – and inequality, environmental degradation and other problems – long before we could measure it. Of course there are thoughtful critics of GDP who suggest additional things we could measure, or ways to make GDP a better measure of economic activity. But the more radical critics seem to assume that our economy is organised the way it is because some sinister force is trying maximise GDP. And that’s just crazy.
A lot of recent thinking talks about happy economics (or what you call happynomics). Does money buy happiness?
Money does buy happiness, it seems – or at least having more money, within a particular society, is correlated with being happier (or rather, with telling surveyors that you are more satisfied with your life). The big contested question in happynomics is whether that’s also true across countries: so, is a richer country such as the US happier than a poorer country such as India?
Is that the case?
Early research from Richard Easterlin suggested that richer countries aren’t happier – hence the phrase “the Easterlin Paradox”: if money buys happiness for individuals but not for countries which are collections of individuals, what’s going on? Two possible explanations: one is that what really counts is relative income. Indians compare themselves to other Indians; Americans compare themselves to other Americans. If Americans compared themselves to Indians they’d feel rich and would be happier. But they don’t, so they don’t. An alternative explanation – favoured by economists Justin Wolfers and Betsey Stevenson – is that Easterlin is just wrong: at the time of his research, the data were of poor quality. Now we have better quality data and we see that money is correlated with happiness both across and within countries. It will be interesting to see this debate play out.
Can economic growth carry on forever?
In principle, yes. Quite a few environmentalists and physicists have pointed out that the planet simply cannot support exponential growth – sooner or later (and, with exponential growth, sooner than we think) we will reach environmental limits.
You don’t buy that?
I regard myself as an environmentalist myself but I think this is just a simple conceptual error. Of course we cannot continue to use more resources or energy at an exponential rate. But economic growth is just growth in the market value of output. So it can continue forever – at least in principle. There are already signs that energy growth is being decoupled from economic growth: in countries such as the UK, the US, Germany and Japan, energy consumption per capita has been falling for a long time now. Population growth is also low or negative in many rich countries. I believe that we need to focus on practical environmental questions – for instance, how to reduce carbon dioxide emissions now – rather than these very abstract concerns about exponentiation.
One of things that you write about India is that “there simply isn’t enough money in India yet for it to be unequal”. What do you mean by that? Do you see it changing in the years to come?
The World Bank economist Branko Milanovic has this idea of the “inequality possibility frontier”. Imagine an extremely poor subsistence society. Then imagine some class of plutocrats, who somehow confiscate wealth and spend it themselves. How much can they take? The answer is: not much if the society is to survive, because the poor cannot dip below the average income because the average income is barely enough to keep you alive. Now imagine a much richer society. This, in principle, could be far more unequal because the poor could still survive on a tiny fraction of the average income. Milanovic and co-authors were interested not only in how unequal a society is, but how unequal it is relative to how unequal it could possibly be. My point was that despite important gains over the past twenty years, India is still a very poor society. There’s a limit to how unequal it can get until it gets richer – which should make us worry about the inequality we do see.
Why was Henry Ford the man who invented unemployment?
Ah yes, this is one of my claims – and I should say that it’s an exaggeration, of course. But here’s the puzzle: Henry Ford of the Ford Motor Company raised wages at his factory to such a level that men were queuing round the block for jobs, being hosed down by police in a sub-zero Chicago January. Why have such high wages? Why not cut them and save money, given how much demand there was for jobs?
The idea here is “efficiency wages” – that it can be efficient for an employer to pay well above the market rate because it gives him the pick of applicants, and a fiercely loyal group of workers who will do almost anything to keep their jobs. And of course, that describes many – perhaps most – jobs in the formal sector today. That means, in turn, that we’ll always have unemployment, not because of some macroeconomic slump, but because individual profit-maximising companies prefer efficiency wages.
You quote a lot of John Maynard Keynes all through the book. One of the things you quote in the last chapter is “the master economist must posses a rare combination of gifts…He must be a mathematician, historian, statesmen – in some degree….” Do you see that in current day economists?
Not enough. But that challenge is what makes economics such a marvellous subject to study. Everything is there in the subject, waiting to challenge us. Despite all the difficulties, economic remains a wonderfully important and rich topic to explore – and it’s still a great time to be an economist.
The interview originally appeared in the Forbes India magazine dated December 13, 2013
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.
Every 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 33rd 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)
Life is a great leveller. The Russians thought they had found an easy way to launder money by simply moving it to banks in Cyprus.
The Cyprian banks thought they had found an easy way to make more money on that money by investing it in Greece.
Trouble started once the Greeks decided that the borrowed money was as good as their own, and did not have to be returned. This left the Cyprian banks reeling with big holes in their balance sheets.
The Cyprian banks were too big to be rescued by the Cyprian government. Hence, they needed to be bailed out by an institution which was bigger than the Cyprian government. The International Monetary Fund(IMF) and the European Union(EU) moved in together and agreed to handover € 10 billion (or around $13billion) to the Cyprian government.
But there was the risk of the Cyprian government also deciding to behave like the Greeks had before them, and treat the € 10 billion bailout as their own money. So, the IMF and the EU demanded some sacrifices to be made by Cyprus as well.
A plan was made to forfeit a part of the deposits lying in Cyprian banks. A levy of 6.75% was proposed on deposits of less than €100,000 and 9.9% on deposits above that. Of course this did not go down well with the people of the country and they protested. So did its Parliament.
The plan was modified. And it was decided that the government will seize deposits greater than €100,000 lying in the Popular Bank of Cyprus (better known as Laiki Bank), the second largest bank in the country.
This move was accepted by Cyprus because deposits greater than €100,000 were largely held by the Russians. As The Huffington Post wrote “The country of about 800,000 people has a banking sector eight times larger than its gross domestic product, with nearly a third of the roughly 68 billion euros in the country’s banks believed to be held by Russians.” Hence, the move of seizing deposits greater than €100,000 did not impact citizens of Cyprus in a direct way. It ended up screwing the Russians. As I said at the beginning life is a great leveller.
But that does not mean that Cyprus would not have to bear any cost of such a move. Cyprus had positioned itself as a tax haven, to attract money from all over the world. And with the government moving to seize deposits greater than €100,000, it has lost its core industry of banking. Russians and other investors across the world who used Cyprian banks to launder money, will think twice before moving any money into the country. They will also move out the money they have in the country, once the capital controls are relaxed. As Ambrose Evans-Pritchard writes in The Telegraph “The country has just lost its core industry, a banking system with assets equal to eight times GDP, and has little to replace it with.”
What this means is that with its core industry gone, its economy is bound to slowdown in the days to come. The financial sector makes up for around 18% of the country’s gross domestic product (GDP). “I wouldn’t be surprised to see a 20% all in real GDP,” Noble Prize winning economist Paul Krugman told Pritchard.
There are other estimates of the Cyprian economy slowdown which are equally scary. As Matthew O’ Brien writes in The Atlantic “the International Institute of Finance thinks Cypriot real GDP could fall as much as 20 % over the next few years…And remember, unemployment is already 14.7% n Cyprus. It could easily climb to 25%.”
To cut a long story short, Cyprus is going to be in a much bad shape than it was in the past. So what is the way out for the country? It needs something to replace its banking and financial sector. The manufacturing sector forms just 7% of its GDP.
Tourism is the other big employer in Cyprus. But since Cyprus moved onto the euro as its currency, on January 1, 2008, tourism has become very expensive. “Cyprus cannot hope to claw its way back to viability with a tourist boom because EMU(Economic and monetary union of the European union) membership has made it shockingly expensive. Turkey, Croatia or Egypt are all much cheaper….The IMF says the labour cost index has risen even faster than in Greece, Spain or Italy since the late 1990s,” writes Pritchard.
In the past countries which end up in such a mess have devalued their currency and exported their way out of trouble. When a country devalues its currency its exports become more competitive. Let me explain this in an Indian context. Let us say an Indian exporter exports a certain good at a price of $100 per unit. When one dollar is worth Rs 50, he gets Rs 5000 per unit. Lets say the value of the rupee against the dollar falls to Rs 60 per dollar. In this case the exporter gets Rs 6000 per unit. So with the value of the rupee falling against the dollar an exporter makes more money.
What the exporter can also do is cut his price in dollar terms. If he cuts his price to $90, he will end up with Rs 5400 ($90 x 60), which is greater than the Rs 5000 he was making in the past. At a lower price, his goods will become more competitive in the international market and thus he will be able to sell more.
Iceland is a very good example of the same. A country of 300,000 people which went financially bust a few years back has been able to get its exports going at some level because its currency the Icelandic Krona, fell in value against the other currencies. “What saved Iceland from mass unemployment after its banks blew up – was a currency devaluation that brought industries back from the dead. Iceland’s krona has fallen low enough to make it worthwhile growing tomatoes for sale in greenhouses near the Arctic Circle,” writes Pritchard.
As The Washington Post reports “Iceland experienced a banking collapse in 2008 during which its currency fell in half, from 60 krona to the dollar to 120. It was a horrible series of events for Iceland, but the collapse in the krona also led to surge in exports and tourism that kept unemployment contained.”
But Cyprus cannot do that given that it does not have a currency of its own. It is a part of a monetary union and euro is used as a currency by sixteen other nations . Cyprus can only devalue its way out of trouble if it chooses to move out of the euro and go back to the Cyprian pound which was its currency before it decided to move to the euro.
As O’Brien puts it “The euro isn’t terribly popular in Cyprus right now. Only 48 % of Cypriots were in favour of the common currency last November…compared to 67 % of Irish, 65 % of Greeks, 63 % of Spaniards, and 57 % of Italians. The euro is actually less popular in Cyprus than anywhere else in the euro zone — and it’s only going to get less so as their economy disintegrates.”
It makes great sense for Cyprus to leave the euro in the hope of getting its export going. Moving back to the Cyprian pound will also get its tourism sector up and running again. Let me explain this by extending the example used above. A tourist looking to visit India is more likely to come when one dollar is worth Rs 60, than when its worth Rs 50. At Rs 60 to a dollar, the tourist can consume goods and services worth Rs 6000 in India, whereas at Rs 50 to a dollar his consumption will be limited to Rs 5000. The same logic works for Cyprus as well if the country decides to leave the euro and move back to the Cyprian pound and devalue the pound against the international currencies.
One fear that has constantly been raised about leaving the euro is the fact that once people find out that there is a threat of a country is leaving the euro and moving on to its own currency, they will rapidly pull out money from the country. This argument works to some extent. In case of Cyprus though, international investors who have put their money in the country will pull out (and have already pulled out) their money irrespective of the fact whether the country remains on the euro or not. As O’ Brien puts it “Countries can’t leave the euro because its banks would collapse and there would be massive capital flight, and … wait. These things have already happened in Cyprus. Its banks just got restructured, and it just instituted capital controls. There’s not much left to lose from euro-exit. And plenty to gain.”
The danger of Cyprian citizens moving out their savings is not very strong. As Albert Edwards of Societe Generale writes in his recent report titled The eurozone is working just fine …as far as Germany is concerned “I know from first-hand experience the extreme difficulty for a European citizen to open an account in another European country it is nigh on impossible for the man in the street.” Given this its highly unlikely that people of Cyprus will be able to move their money out of the country. But that is no guarantee that money will continue to remain in Cyprian banks. As Edwards put it, people have the “choice of stuffing” their “money under the mattress or buying safe financial assets (maybe overseas mutual funds or gold?), or indeed spending the money on goods and services.” (For a more detailed argument on how a country should move out of the euro in a somewhat orderly manner click here).
The country has no plans of leaving the euro currently. Nicos Anastasiades , the President of Cyprus said on March 29, 2013 that “We have no intention of leaving the euro…In no way will we experiment with the future of our country.”
If Cyprus does decide to leave the euro that might encourage other countries to do so as well. There are several countries which could face a Cyprus type of bailout in the days to come. As Guy Verhoftstadt, a former prime minister of Belgium writes in The New York Times “Perhaps Malta, which has an even bigger banking sector than Cyprus relative to G.D.P., much of it highly reliant on offshore depositors. Or maybe Latvia, fast becoming the destination of choice for Russian funds flowing out of Cyprus and now on course to join the euro zone. Even Spain or Italy could be vulnerable to a similar bailout, now that the Dutch finance minister, Jeroen Dijsselbloem, who is president of the Euro Group of finance ministers, has hinted that Cyprus could provide a model for the resolution of future banking crises.”
Given this, the future of the euro looks very dicey. As Martin Wolf, one of the foremost economic commentators of the world, wrote in a recent column in the Financial Times “Old fears that the euro would undermine European unity rather than strengthen it seem more plausible.” Nobody could have put it better.
(Vivek Kaul is a writer. He tweets @kaul_vivek)
When the going gets tough, the ideas get absurd and bizarre. No one said that. I just happened to ‘coin’ it after coming across one of the craziest things I have heard in recent times. It all about ‘coining’ a trillion dollar platinum coin that could ‘supposedly’ solve one of the biggest financial problems of our times. But before we get to that some background information is required here.
The American government cannot print money
The budget deficit of the American government has been greater than trillion dollars for the last four years. Budget deficit is the difference between what a government earns and what it spends.
In order to finance this deficit the American treasury department (or what we call the ministry of finance in India) borrows money. But there is only so much money going around to be borrowed. And with trillion dollar deficits borrowing beyond a point is not possible.
So what does the government do? Common sense tells us that it can print dollars and finance the deficit. But the American government is not allowed to print money. Instead it borrows from the Federal Reserve of the United States (the American Central bank or what we call the Reserve Bank of India).
Now where does the Federal Reserve get money to lend to the government? It simply prints it. The Federal Reserve as the central bank is allowed to print money. As John Truman Wolfe author of Crisis by Design: The Untold Story of the Global Financial Coup puts it “How bizarre is it that instead of simply printing the money themselves, governments “chose” to borrow it from their respective central bank. The US 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 (who 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.”
The debt ceiling
There is a ceiling to how much the American government can borrow and it is $16.4trillion. This was breached on December 31, 2012. After this the treasury secretary Timothy Geithner put in place some “extraordinary measures” that will give a headroom of round $200 billion and help the American government avoid a default on its maturing debt as well as continue meeting its various expenditures. The American government has reached a stage where it has to take on more debt to pay off previous debt. But with the debt ceiling being hit more debt cannot be taken on. The American politicians have been unable to find a solution to this till date.
The US Code Section 5112 states this:
“The (Treasury) Secretary may mint and issue platinum bullion coins and proof platinum coins in accordance with such specifications, designs, varieties, quantities, denominations, and inscriptions as the Secretary, in the Secretary’s discretion, may prescribe from time to time.”
The above section basically allows the American Treasury Secretary to mint absolutely any kind of platinum coin. When it comes to gold and silver coins, he is not allowed such a leeway. The Code prescribes the exact dimensions as well as weights of gold and silver coins that can be minted. In case of platinum coins no such prescriptions are made.
So what is the idea?
This loophole allows the Treasury Secretary of the United States to get the US Mint to mint a platinum coin and deem it be worth $1trillion (or any big amount for that matter). The amount of platinum in the coin doesn’t really matter. It could be one gram or one troy ounce (28.31 grams). Hence the face value of the coin (i.e. $1trillion) would have no link with the amount of platinum in it.
Having minted such a platinum coin, the Treasury Secretary can then use the coin to repay the money that it has borrowed from the Federal Reserve. The Federal Reserve would have to accept the coin simply because any creditor cannot refuse what is legally deemed to be money, when it comes to the settlement of a debt. And the $1trillion coin would be a legal tender.
Once the $1 trillion coin is presented to the Federal Reserve, the total debt outstanding of the American government would come down below the debt ceiling of $16.4trillion. As on January 2, 2013, the American government had borrowed around $1.67trillion from the Federal Reserve. And that way the American government could continue to borrow more.
The Krugman push
The Nobel prize winning economist Paul Krugman gave a push to the idea by recommending it on his blog a couple of days back. Krugman feels that even though the idea is silly it makes sense simply because the US Congress has the right to approve the spending bills but then it won’t let the President to borrow money required to implement those bills.
As Krugman wrote “we have the weird and destructive institution of the debt ceiling; this lets Congress approve tax and spending bills that imply a large budget deficit — tax and spending bills the president is legally required to implement — and then lets Congress refuse to grant the president authority to borrow, preventing him from carrying out his legal duties and provoking a possibly catastrophic default.”
There are others who do not buy the idea at all. As Kevin Drum, a famous blogger, wrote recently “Is this really the road liberals want to go down? Do we really want to be on record endorsing the idea that if a president doesn’t get his way, he should simply twist the law like a pretzel and essentially do what he wants by fiat?”
The big danger in this case is that if something like this were to be implemented, the American government can easily keep getting the Federal Reserve of United States to keep printing money and keep repaying that money through issuing one trillion dollar platinum coins. That cannot be a good idea after all. A government which has the power to print unlimited amount of money, even though indirectly, is not something that world wants, specially given that the dollar continues to be the international reserve currency.
To conclude, it is ‘absurd’ ideas like these that make me remain bullish on gold despite the recent attempts to discredit the yellow metal as being useless.
The article originally appeared on www.firstpost.com on January 9, 2013
(Vivek Kaul is a writer. He can be reached at [email protected])
High risk means high returns.
Or does it?
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.
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])