It was around this time in 2008, that the Federal Reserve of United States, the American central bank, started printing money to buy bonds. This process came to be referred as quantitative easing(QE) and gradually spread to other central banks in the Western world.
When the process was first initiated many writers (including yours truly) said that high inflation was on its way in the United States. Comparisons were made to Zimbabwe which was facing hyperinflation at that point of time.
In July 2008, a few months before the financial crisis broke out, the British newspaper Guardian reported that ordinary hen’s eggs were selling at $50billion each. These were not American dollars, but dollars issued by the Reserve Bank of Zimbabwe. Between August 2007 and June 2008, the money supply in Zimbabwe had gone up 20 million times.
With the money supply increasing by such a huge amount, inflation went through the roof. In early 2008, consumer price inflation was said to be at 2 million percent. By the end of the year it had reached around 230 million percent.
The feeling was that United States was headed towards something similar, though not of a similar proportion. Five years on, people who felt that way, continue to be proven wrong. Inflation levels in the United States and much of the Western world continue to remain very low. The consumer price inflation in the United States was at 1% in October 2013. This is the lowest it has been at since October 2009.
So the question is why is there has been no inflation? As Niels C Jensen writes in The Absolute Return Letter dated November 7, 2013 “The reality is that we have seen plenty of inflation already from QE – just not in the places nearly everyone expected it to show up. Asset price inflation is also inflation, and we have had asset price inflation galore. Many emerging economies have struggled with consumer price inflation in recent times. It looks as if we have been very good at exporting it.”
Countries printed money with the intention of ensuring that there would be enough money going around in the financial system and this would lead to low interest rates.
At lower interest rates people would borrow and spend more, and this in turn would revive economic growth, which had dried up in the aftermath of the financial crisis, which broke out in September 2008, after investment bank Lehman Brothers went bust.
But people had other ideas. They had borrowed and speculated in the real estate market between 2002 and 2008. Once the real estate bubble burst, they were left hanging onto homes, with considerably lower market values. The loans that people had taken still needed to be repaid. Hence, they wanted to repair their individual balance sheets and did not want to take on any more loans. They were more interested in repaying their outstanding loans.
In this scenario, there was little demand for loans from individuals. Financial firms cashed in on this by borrowing money at close to 0% interest rates and investing it in financial and other markets all over the world. And this has led to what economists call asset price inflation, where stock markets and other markets, are at very high levels, even though the underlying fundamentals don’t justify that. The trouble is when these bubbles burst they will create their own set of problems.
There is another reason behind why people are not borrowing even though interest rates are at very low levels. Jensen calls this the impact of the rational expectations hypothesis. As he writes “economic agents (read: consumers and businesses) make rational decisions based on their expectations. So, when the Fed – and other central banks with it – keep ramming home the same message over and over again (and I paraphrase): “Folks, we will keep interest rates low for some considerable time to come”, consumers and businesses only behave rationally when they postpone consumption and investment decisions. They have seen with their own eyes that central bankers have been able to talk interest rates down, so why borrow today if one can borrow more cheaply tomorrow?”
So the longer people postpone their borrowing, the longer government and central banks will have to keep printing money in order to keep interest rates low, in order to entice them to borrow.
In fact, interest rates are so low that banks are also not in the mood to lend. They would rather use the money that they have in proprietary trading activities. This explains to a large extent why financial firms have been borrowing and investing money in financial markets all over the world. While, money printing hasn’t exactly led to what central banks thought it would lead to, it has benefited governments tremendously. This is primarily because money printing has ensured that interest rates continue to remain at low levels and has allowed governments to borrow easily at ridiculously low interest rates.
As William White writes in a research paper titled Ultra Easy Monetary Policy and the Law of Unintended Consequences “Indeed, long term sovereign rates in the US, Germany, Japan and the UK followed policy rates down and are now at unprecedented low levels. However, there can be no guarantee that this state of affairs will continue. One disquieting fact is that these long rates have been trending down, in both nominal and real terms, for almost a decade…Many commentators have thus raised the possibility of a bond market bubble that will inevitably burst.”
This has led to government debts exploding. “Italy’s government debt has jumped from 121% to 132% of GDP over the past two years alone. Spain’s debt-to-GDP has gone from 70% to 94% and Portugal from 108% to 124% over the same period. An interesting brand of austerity I might add! Expanding the government deficits at such speed would have been devastatingly expensive in the current environment without QE,” writes Jensen.
Money printing has been bad for old people. The corpus they had saved for their retirement has hardly been able to generate an income that is good enough to live on. This has impacted people in the United States as well as Europe.
Also, a new stream of research coming out seems to suggest that money printing has an impact on income growth and in turn economic growth. “Charles Gave of GaveKal Research produced a very interesting paper earlier this year, linking the low income growth to QE – another nail in the coffin for economic growth. Charles found that during periods of negative real interest rates (which is a direct follow-on effect from QE), income growth in the U.S. has been low or negative,” writes Jensen.
This is primarily because when interest rates have been low for a very long period of time and are expected to be low for the years to come, there is very little incentive for the private sector to either hire new workers or increase capital spending. And when this happens income growth is more than likely to stagnate. This has an impact on consumer demand, which in turn influences economic growth.
John Mauldin captured this idea beautifully in a recent column where he wrote “The belief is that it is demand that is the issue and that lower rates will stimulate increased demand (consumption), presumably by making loans cheaper for businesses and consumers. More leverage is needed! But current policy apparently fails to grasp that the problem is not the lack of consumption: it is the lack of income.”
Once these factors are taken into account it is easy to suggest that it is time that the Western central banks and governments wound up their money printing plans. It is time for quantitative easing to come to an end. As Jensen puts it “It is time to call it quits. QE proved to be a very effective crisis management tool, but we have probably reached a point where the use can no longer be justified on economic grounds. The obvious problem facing policy makers, though, is that if financial markets are the patient, QE is the drug that keeps the underlying symptoms under control.”
Financial firms have been able to borrow money at close to 0% interest rates and invest it in financial markets all over the world. This is because quantitative easing or money printing has managed to keep interest rates at very low levels. Once money printing is stopped or even slowed, interest rates will start to rise. This will mean that asset bubbles all over the world will start to burst, which will create its own set of problems.
And that is the real problem. The question is who will blink first? The central banks or the financial markets?
The article originally appeared on www.firstpost.comon November 27, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)