Saturday, 13 November 2010

Turn on your printing machines

This post may be treated as a follow-up to my short essay on monetary policy from December 2009. On 3 November Mr Bernanke, the governor of Federal Reserve Bank, announced the launch of QE2 programme under which the central bank of USA will buy up government securities in the total amount of 600 billion dollars to kick-start US ailing economy.

Almost two years after Fed’s discount rate was slashed to 0.00% – 0.25% range US economy is still in the doldrums. Unemployment rate fluctuates around 10%, figures of economic growth are positive mainly thanks to large-scale stimulus programmes which slowly peter out (the two factors above combined give a new buzz-phrase “jobless recovery”), consumer prices also levelled off, but central bankers say despite extremely loose monetary policy deflation is still a much bigger threat than inflation.

The recent crisis has changed American consumers’ habits. Before the meltdown an average American household had negative savings and consumers generally tended to consume more than could afford, thus propelling world economy. This was easy to attain, as banks were eager to provide them with lending and turned a blind eye on creditworthiness criteria many borrowers didn’t meet. Much has changed since then. Consumers are now reluctant to part with cash they have, their propensity for spending and borrowing has declined. The tough lesson of crisis they have learnt will probably bring about a gradual shift from spending and borrowing towards saving.

Also banks, severely hit by write-offs on bad loans have modified their credit policies. Gone are the times when credits were foisted upon not creditworthy borrowers, these days bankers think twice before the grant a loan. Just think what happens when a loan goes bad. Can it be prevented? Can financial standing of a debtor be monitored effectually? Probably not. How long does it take to recover money? Sometimes years. What the recovery ratio will be? No one knows – a bank can recover principal and interest, a principal only or nothing, and costs have to be borne to wrangle with bad loans. Is there any alternative? Is something less risky?

Regular readers of this blog surely remember the story of 1,000 PLN lent to an ex-classmate. I still didn’t get that money back. For a comparison, on my worst speculation on stock market I lost 23%, so out of 1,000 PLN put in I still could put out 770 PLN (minus transaction costs), so it’s much more than zero. Stock markets look like an alternative. Stock indices reached their many-year lows in late winter 2009, bottomed out and since then have risen by 50% - 100%. The bull run was spurred on by loose monetary policy. Ample liquidity provided by central banks was not directed at lending activities, but at stock and commodity markets. Yes, the capital markets are said to anticipate changes in real economy, but this time market valuations discounted a rapid recovery owing to a flow of newly printed money. Just look at it from the perspective of a bank. A central bank gives you an unlimited credit facility, you begin to buy fundamentally undervalued stocks. If you don’t have power to drive the market up, you just pull back. Such a scenario is unlikely, so the prices do go up and because you are obliged to comply with mark-to-market accounting rules, your profits also rise. You report profits to shareholders and get a generous bonus from them. This is how it works… And there’s no need to grapple with bad debts, positions can be closed as quickly as they were opened and after all at the end of the day stocks will be distributed to some nitwits who will believe the prices will be rising forever and eventually will be end up duped. Stocks seem riskier assets than loans, but for the reasons I delineated above I think this is where the money from QE2 will go.

I forgot to mention the mechanics of the programme. Fed will not be buying up securities from individual holders but from financial intermediaries, i.e. banks, with a view to provide them with extra liquidity that should buoy up the economy through bank credit channel. However, the Fed is not in the authority to tell banks to turn the new money into corporate loans. Bank are free to do with that money whatever they won’t and this money in the long term will cause lots of bubbles on asset markets (excluding real estate market) to arise. The beneficiaries of the programme will be mostly financial institutions and other speculators who might strike it rich on increasing market prices. The programme might result even in hampering recovery, mostly if prices of commodities (crude oil, copper, even food) shoot up. Finally, it will cause US dollar to depreciate against other currencies and make US exports more competitive. And in the long run the rising money supply will result in higher inflation. I surmise Fed in liaison with US government were absolutely aware of long-term implications of this decision, mostly because it will allow US government to pay off its whopping debts, at the expense of its creditors, at the expense of the rest of the world actually.

Markets have witnessed a substantial rally from the beginning of August as speculators have anticipated the move of Fed, they could only bet how big the scale of the programme would be. Fed met their expectations, but hopes for a continued rally in the coming months might be dashed. Markets have priced the programme before, another price surge will ensue soon as the new money has to be allocated somewhere, but a significant correction should not come as a surprise. How long can stock prices rise if the economy is on its knees and even near-zero interest rates and printing money fail to bolster it up?

The experts tear Mr Bernanke’s move into pieces. One of the most eminent investors, Jim Rogers said the governor of US central bank “doesn’t understand economics (…) all he understands is printing money”. I would like to remind you mustn’t turn on your printers and print as much money as you want because you or your friends are hard up for cash. It is a crime! But Mr Bernanke can do it and he is not dubbed a criminal.

For the past few days I’ve been mulling over a concept of economic crime. Is there anything like this? In Poland we have police departments that deal with przestępczość gospodarcza those are economic crimes, but I’d prefer “business crimes” term. In Polish public discourse there is an insult szkodnik gospodarczy (economic pest), used by Andrzej Lepper and his fellows to describe Leszek Balcerowicz and his fellows, or conversely, by liberal intellectuals to name statist populists. But I don’t recall hearing about zbrodnia ekonomiczna.

General Wojciech Jaruzelski chose the lesser of two evils and declared martial law, many Poles have forgiven him. Current prime minister failed to carry out painful, but necessary reforms, but if he had had more courage, many Poles with hindsight would forgive him. Will the world forgive Mr Greenspan and Mr Bernanke their thoughtless decisions?

I believe one day we’ll bear the brunt of what is getting under way now. The next financial meltdown will be much more severe because indebted government will not be able to step in and bail out financial institutions on the verge of bankruptcy. I don’t claim to have come up with this scenario. Many far wiser people have spoken about such scenarios much earlier, it is estimated to come to a pass in 2014 or 2015. Before it happens we will witness era of super bubbles, so take advantage of it before the whole machinery goes under :)


odrzut said...

Sorry I'm nitpicking, but I couldn't left this unnoticed.

"General Wojciech Jaruzelski chose the lesser of two evils and declared martial law, many Poles have forgiven him."

There is no evidence it was lesser evil. Most evidences suggests that USSR would not invaded us then.

If that's the case Jaruzelski is not only guilty of 1000s of unnecessary deaths, but also of postponing Poland independence and recovery by 10 years.

student SGH said...

Great you've had your say. That's what the comment box is designed for.

Those people who think it was the lesser of two evils have forgiven him.

Odrzut, read this post to find out what my personal opinion on martial law is.

Where did you find the number of victims of martial law? Wikipedia cites research carried out by IPN and death are numbered in tens rather than thousands - to be precise death toll was 56.

Do you really think it was possible to break away from teh Soviet bloc in 1981. In humble opinion before Gorbachev took over the risk that armies of Warsaw Pact could put down the uprising was high.

odrzut said...,prof-pipes-reagan-byl-wsciekly-na-sowietow,id,t.html#material_2

There is opinion of prof. Richarde Pipes, advisor of president Ronald Reagan. To question "Pułkownik Kukliński przekazał jeszcze jakieś inne informacje? Np. odnośnie do tego, czy groźba wkroczenia do Polski wojsk Układu Warszawskiego była realna?
he answers: "To, że była to pusta pogróżka, wiedzieliśmy i bez niego. Wkroczenia wojsk Układu spodziewaliśmy się na
początku 1981 roku. Na zdjęciach satelitarnych, które regularnie otrzymywałem, było wtedy widać skupiska wojsk radzieckich i innych. Pod koniec tego roku zdjęcia satelitarne niczego takiego już nie pokazały. ZSRR co najwyżej mógł zastosować względem Polski ekonomiczne represje - na przykład odciąć dostawy gazu. ".

About numbers - OK, my bad, I've got these 1000s from memory, and my memory is highly opinionated in this case, it seems.

student SGH said...

ZSRR co najwyżej mógł zastosować względem Polski ekonomiczne represje - na przykład odciąć dostawy gazu. - do you realise what cutting off supplies of natural gas could mean for Poland?

Teraz wiemy, że on się strasznie wahał, a na niego napierali. Przyjeżdżali bezustannie do niego, naciskali na niego i grozili mu. (...) Generał i marszałek opowiadali wtedy nieoficjalnie, że stan wojenny wprowadzili, bo strasznie bali się dużej demonstracji Solidarności, która była zaplanowana na 17 grudnia. Alright, what do you think would the Soviets have done if Jaruzelski had made up this mind not to declare martial law and Solidarity would have staged the aforementioned demostration?

Jaruzelski strasznie się bał wybuchu wojny cywilnej w Polsce. I don't know how old you are odrzut, I'm turning 23 in December co I can't remember those days, but I can assure you I know a lot of people who feared a civil war (btw - civil war is wojna domowa translators...)

Te zrywy wolnościowe miałyby szansę się rozprzestrzenić, do czego Rosjanie nie mogli dopuścić. - so this might be the answer to the question "what is Solidarity had overthrown Jaruzelski?" It they couldn't let happen, why should they have stood by and see Poland breaking away from Soviet sphere of influences?

Best wishes :)