The Age of Turbulence

Yellen does a Greenspan, talks about “irrational exuberance” in the stock market

yellen_janet_040512_8x10Vivek Kaul

Janet Yellen, the chairperson of the Federal Reserve of the United States, said yesterday: “equity market valuations at this point generally are quite high…There are potential dangers there.” This is the strongest statement that Yellen has made against the rapidly rising stock markets in the United States and other parts of the world.
In February earlier this year Yellen had said that the stock prices where “somewhat higher than their historical average levels.” In March, she had followed this up by saying that the stock market valuations were “on the high side”.
Central bank governors don’t say things just like that on the stock market, like the stock market analysts tend to do. When a central bank governor makes his view public on the stock market, the idea is to temper down the expectations of stock market investors in some way.
Take the case of a speech that Alan Greenspan, who was the Chairperson of the Federal Reserve between 1988 and 2006, gave on December 5, 1996. In this speech Greenspan said: “Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance[emphasis added] has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade.”
Greenspan was essentially saying that the stock market level might have run way ahead of the kind of earnings that were being generated by companies. And hence there was an “irrational exuberance”.
Greenspan recalls in his autobiography The Age of Turbulence that at the end of the speech, he wondered whether people would understand what he was trying to get at. They sure did.
The Japanese stock market, which had opened by the time Greenspan finished his speech, reacted instantly. The Nikkei index dropped 3.2 percent. The Hang Seng in Hong Kong dropped 2.9 percent. The DAX in Germany went down four percent and so did the FTSE 100 in London.
The next day, when the stock markets in the United States opened for trading, the Dow Jones Industrial Average, America’s premier stock market index, was down 2.3 percent. The NASDAQ Composite Index, where most of the technology companies listed, was down 1.8 percent at opening.
By the close of trading, NASDAQ Composite Index was down 0.9 percent and had recovered half of its losses. When the stock market opened for trading again on December 9, 1996, after the weekend, it was back trading at the levels it had been at before Greenspan made the “irrational exuberance” speech.
Various explanations have been offered over the years as to why the stock market investors chose to ignore what Greenspan had said and continued to stay invested in the dotcom bubble. One is that Greenspan did not immediately back his speech with the concrete action of raising interest rates. This argument is not totally correct because Greenspan did raise interest rates a couple of months later, although he did not do anything immediately. The second reason given is that by the time Greenspan raised the red flag, the market was already irrationally exuberant. It had already formed a mind of its own and was in no mood to listen. As the economist Ravi Batra writes in Greenspan’s Fraud: “The lure of free lunch is so powerful that it clouds our vision. For once Greenspan had offered words of wisdom, but in doing so he lost his audience. The master bartender wanted his customers to sober up. They wanted more: whiskey, champagne, rum, just bring it on.”
The stock market needed a little more than just one Greenspan speech to sober up. A series of interest rate hikes might just have done the trick. But this can only be said with the benefit of hindsight. Nobody likes to spoil a party that is on. Greenspan too was human, and he did not want to be a killjoy.
So what is it that we can learn when we compare Greenspan’s warning with those made by Yellen in the recent past. Yellen’s warnings on the stock market like that of Greenspan might also have come a little late in the day. But unlike Greenspan who just made one warning and then more or less kept quiet, till the dotcom bubble burst in 2000, Yellen has come up with a series of warnings. If she keeps saying the things she has been the investors will eventually take her seriously. The only question is when.
Further, just talking about stock market being overvalued won’t help. If Yellen has to rein in the stock market then the Federal Reserve also needs to start raising the interest rates. The trouble is that with the American gross domestic product(GDP) growing by just 0.2% between January and March 2015, Yellen and the Fed are not really in a position to start raising interest rates.
In fact, what makes the economic situation even more worse than it actually looks is the fact that even a 0.2% economic growth is overstated. This is primarily because it includes a huge inventory build up. Inventory essentially refers to goods which are being produced but not being sold.
Inventories during the period January and March 2015 went up by $110.3 billion. They had risen by $80 billion during the period October to December 2014. An increase in inventory adds to the GDP. Nevertheless what it also means is that there will be production cuts in the months to come, which in turn will pull the GDP down. Albert Edwards of Societe Generale estimates that without this unprecedented rise in inventories, “GDP would rather have declined by some 2½%!” He also said in a recent research note that: “The US economy is struggling and the Fed will ultimately re-engage the QE spigot.” QE or quantitative easing is the technical term that economists use for a central bank printing money and pumping that money into the financial system to keep interest rates low.
Until October 2014, the Federal Reserve had been printing money and pumping money into the financial system by buying government bonds and mortgaged backed securities. The idea was to flood the financial system with money by buying bonds and drive down interest rates. At lower interest rates, people were more likely to borrow and spend money. This would help businesses and in turn, the overall economy. While this happened to some extent, what also happened was that institutional investors borrowed money at low interest rates and invested them in financial markets all over the world. This led to stock market rallies all over the world.
Hence, while Yellen might keep making statements about the stock markets being overvalued, she needs to back it up with some concrete action(like raising interest rates) for investors to take her seriously.
The trouble is Yellen can’t raise interest rates. At least, not in near future. Given the American economic growth scenario, an era of low interest rates and easy money is likely to continue in the days to come. And what this means is that BSE Sensex just might go back to rallying despite the recent fall.

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

The column originally appeared on Firstpost on May 7, 2015

No, Subbarao won’t be able to clean UPA’s garbage dump


Vivek Kaul

Duvvuri Subbarao, the current governor of the Reserve Bank of India must be a troubled man these days, professionally that is. The gross domestic product (GDP) growth has fallen to 5.3% for the period of January to March 2012. And now he is expected to come to the rescue of the Indian economy by cutting interest rates, so that people and businesses can easily borrow more, and we all can live happily ever after.
Cows would fly, only if it was as simple as that!
The mid quarter review of the monetary policy is scheduled for June 18,2012. On that day the Subbarao led Reserve Bank of India(RBI) is expected to cut the repo rate by at least 50 basis points (one basis point is one hundredth of a percentage). The repo rate is the rate at which banks borrow from the RBI.
Repo rate is a short term interest rate and by cutting this interest rate the RBI tries to manage the other interest rates in the economy, including long term interest rates like the rate at which the bond market lends to the government, the interest offered by banks on their fixed deposits, and the interest charged by banks on long term loans like home loans, and loans to businesses.
But the fact of the matter is it really has no control on these interest rates in the current state of things. To understand why, let us deviate a little.
Greenspan and Clinton
Alan Greenspan and Bill Clinton came from the opposite ends of the political spectrum. Greenspan had been a lifelong Republican whereas Clinton was a Democrat. Unlike India where there are a large number of political parties, America has basically two parties, the Republican Party and the Democratic Party. Greenspan was the Chairman of the Federal Reserve of United States, the American central bank, from 1987 to 2006.
But despite coming from the opposite ends of the political spectrum they got along fabulously well. In fact, when Clinton became the President of America in early 1993, Greenspan approached him with what Americans call a “proposition”.
Greenspan told Clinton that since 1980 the rate of inflation had fallen from a high of around 15% to the current 4%. But during the same period the interest rate on home loans had fallen only by 400 basis points from 13% to 9%. Despite the fact that the Federal Funds Rate (the American equivalent of the Indian repo rate) stood at a low 3%.
Why was the difference between the Federal Funds rate which was a short term interest rate and the home loan interest rate, which was a long term interest rate, so huge?
High fiscal deficit
The difference in interest rates was primarily because of the high fiscal deficit that the government of United States was incurring. Fiscal deficit is the difference between what the government earns and what it spends in a particular year.
When Clinton took over as President on January 20, 1993, the American government had just run a record fiscal deficit amounting to $290.3billion or 4.7% of the GDP for 1992. And this had led to high long term interest rates even though the Federal Reserve had set the short term Federal Funds rate at 3%.
The government was borrowing long term to fund its fiscal deficit. And since its borrowing needs were high because of the large fiscal deficit it needed to offer a higher rate of interest to attract lenders. When the government borrowed more it crowded private borrowing, meaning, there was lesser pool of “savings” for the private borrowers to borrow from.
Hence, banks and other financial institutions which needed to borrow in order to give out home loans had to offer an even higher rate of interest than the government to attract lenders. Even otherwise, the private sector has to offer a higher rate of interest than the government, because lending to the government is deemed to be the safest form of lending. Due to these reasons the difference in short term interest rates and long term interest rates in the US was high. So the repo rate was at 3% and the home loan rate was at 9%.
The proposition
Greenspan was rightly of the opinion that a high fiscal deficit was holding economic growth back. This was the argument he made to President Clinton when he first met him. As Greenspan writes in his autobiography The Age of Turbulence – Adventures in a New World “Long term interest rates were still stubbornly high. They were acting as a brake on economic activity by driving up costs of home mortgages (the American term for home loans) and bond issuance.”
Other than the government which issues bonds to finance its fiscal deficit, companies also issue bonds to raise debt to meet the needs of their business. If interest rates are high companies normally tend to put expansion plans on hold because high interest rates may not make the plan financially viable.
Greenspan’s proposition to Clinton was that if the Wall Street got enough of a hint that the government was serious about bringing down the fiscal deficit, long term interest rates would start to fall . This would be good for the overall economy because at lower interest rates people would borrow more to buy houses and as well as everything else that needs to be bought to make a house a “home”.
As Greenspan writes “Improve investors’ expectations, I told Clinton, and long-term rates could fall, galvanizing the demand for new homes and the appliances, furnishings, and the gamut of consumer items associated with home ownership. Stock values too, would rise, as bonds became less attractive and investors shifted into equities.”
The US Congressional and Budget Office(CBO), a US government agency which provides economic data to the US Congress (the American parliament) to help better decision making, upped its projection of the fiscal deficit at that point of time. It said that the fiscal deficit is likely to reach $360billion a year by 1997. This data point put out by the US CBO helped buttress Greenspan’s point further and Clinton decided to do something about the fiscal deficit.
The Clinton plan
Clinton put out a plan which would cut the deficit by $500billion over a period of four years through a combination of higher tax rates as well as lower spending by the government. The fiscal deficit of the United States of America which had been growing steadily for years, started to fall from 1993. In 1993, it was down by 12% to $255billion. By 1997, the fiscal deficit was down to $21billion. In Clinton’s second term as President, the deficit turned into a surplus, something that had not happened since 1971. Between 1998 and 2001, the US government earned a surplus of $559.4billiondollars.
A lower fiscal deficit led to lower long term interest rates and good economic growth. The United States of America grew at an average rate of 3.9% between 1993 and 2000. In the eight years prior to that the country had grown at an average rate of 2.9% per year. So the US grew at a much faster rate on a higher base because the fiscal deficit was turned into a fiscal surplus.
This was also the period of the dotcom bubble but the fiscal surplus was clearly not the reason for it.
The moral of the story
As we clearly see from the above example, at times there is not much that a central bank can do on the interest rate front, especially when the government is running a high fiscal deficit. As I have often said over the past one month the fiscal deficit of the government of India has increased by 312% between 2007 and 2012. During the same period its income has increased by only 36%. The fiscal deficit target for the current financial year is at Rs Rs 5,13,590 crore, a little lower from the last year’s target. But as we have seen in the past this government has a tendency to miss its fiscal deficit targets regularly. So the government will have to borrow to finance its fiscal deficit and that means an environment in which long term interest rates will remain high.
In fact, some banks have quietly raised the interest rates they charge to their existing home loan borrowers, after the Subbarao led RBI last cut the repo rate by 50 basis points on April 17, 2012.
The interest being charged to some of the existing home loan borrowers has even crossed 14.5%, a difference of more than 6% between a long term interest rate and the repo rate, as was the case in America.
India has another problem which America did not in the early 1990s, high inflation. The consumer price inflation was at 10.36% for the month of April 2012. Urban inflation was at 11.1% whereas rural inflation was just below 10% at 9.86%. If Subbarao goes about cutting the repo rate in a rapid manner, he runs the danger of inciting further inflation.
So the only way out of this mess is to cut subsidies. Cut fuel subsidies. Cut fertilizer subsidies. This of course would mean higher prices in the short term, particularly if diesel prices are raised. An increase in the price of diesel will immediately lead to higher inflation, given that diesel is the major transport fuel, and any increase in its price is passed onto the consumers. The government thus has to make a choice whether it wants high interest rates for the long term or high inflation for the short term. It need not be said it will be a politically difficult decision to make.
Over the longer term it also needs to figure out how to bring more Indians under the tax ambit and lower the portion of the “black” economy in the overall economy. (You can read this in detail here: It’s not Greece: Cong policies responsible for rupee crashhttp://www.firstpost.com/economy/dont-blame-greece-cong-policies-responsible-for-rupees-crash-318280.html)
And there is nothing that RBI can do on any of these fronts. The predicament of the RBI was best explained in a recent column titled Seeking Divine Intervention, written by Rajeev Malik, an economist at CLSA. He said: “There are three institutions that keep India running: the Supreme Court, the Election Commission and the Reserve Bank of India (RBI). To be sure, most of the economic mess in India has the government behind it. And often the RBI is called in as a vacuum cleaner. But even the world’s best vacuum cleaner cannot be successfully used to clean up a garbage dump.”
(The article originally appeared at www.firstpost.com on June 4,2012. http://www.firstpost.com/economy/no-subbarao-wont-be-able-to-clean-upas-garbage-dump-331114.html)
(Vivek Kaul is a writer and can be reached at [email protected])