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MUMBAI : He woke up to Bruce Springsteen singing: “We’re going on the town now looking for easy money," and a fresh cup of black coffee that she brought him.

“I had never heard this song before," he told his economist girlfriend.

“Well, there is always a first time, love," she told her out-of-work boyfriend who used to work for a unicorn.

“But now that we are talking about easy money, tell me something… why are stock prices on fire?"

“You want to start a Monday morning talking about stocks…and here I was thinking we will spend time doing a little bit of this and that…perhaps even binge watch the last season of Better Call Saul."

“So, why did the Sensex cross 60,000 points again, before falling on Friday?" he asked, totally ignoring what she had just said.

“Men will be men!" she thought.

“Tell me na," he persisted.

“So, on 18 October last year, the Sensex closed at an all-time high of 61,766 points."

“That I know."

“By 17 June it had fallen by around 17% to around 51,360 points. This happened primarily because the rich-world central banks led by the Federal Reserve of the US, in order to control decadal-high inflation, decided to start raising short-term interest rates. They also decided to gradually take out the money they had printed and pumped into the financial system over the years, in order to drive down long-term interest rates."

“This is what the experts meant when they said that the era of easy money had come to an end?" he asked.

“Yes," she replied.

“So, what happened post 17 June?"

“We need to first understand what happened before that."

“Okay."

“Any market does not wait for things to happen. It discounts possibilities. And that’s what was happening with stocks, especially when it came to foreign institutional investors (FIIs) who invest in Indian stocks."

“As in?"

“While the rich-world central banks decided to reverse their easy money policy only this year, the FIIs had been discounting this possibility since late last year. They did this by selling out a portion of their holdings in Indian stocks. Between October and June, the FIIs sold stocks worth 2.56 trillion."

“Wow!

“During the same period, the domestic institutional investors (DIIs)…"

“Domestic institutional what?" he interrupted.

“Domestic institutional investors," she said. “They are basically firms like mutual funds, insurance companies, pension and provident funds, banks, etc. Much of the money they invest is money handed over to them by retail investors."

“Ah, the money that you and I invest indirectly in the stock market."

“Yes, exactly that."

“What did the DIIs do?" he asked.

“Between October and June, they bought stocks worth 2.98 trillion and that ensured that the market only fell as much as it did and not more."

“Now, what has changed since June?"

“The FIIs are back."

“Okay."

“So, the FIIs turned buyers in early July and on the whole have bought stocks since then. In July, they bought stocks worth 4,989 crore (net), which wasn’t much. But they really came to the party this month. As of 19 August, they had bought stocks worth 44,481 crore (net) during the month."

“Why this change?"

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“To answer this question, we will need to understand a little bit of economic history."

The backstory

“Bring it on," he replied, all excited. That left her wondering—when did their relationship become so intellectual?

“So, do you know about the Great Depression of 1929?"

“Not like you possibly know about it."

“Aah, maska polish!"

“Well!"

“The year was 1929 and by October, stock prices in the US had run up quite a bit. On 3 September 1929, the Dow Jones Industrial Average, America’s premier stock market index, peaked at a little over 381 points."

“And then what happened?" he asked.

“By 17 October, the stock market had fallen more than 10% from its peak on 3 September. At that point, Irving Fisher, possibly the greatest American economist of that era, remarked, ‘Stock prices have reached what looks like a permanently high plateau…I expect to see the stock market a good deal higher within a few months.’"

“Ah, experts being experts."

“The week of 21 October set the shape of things to come. By the end of the week, the Dow was down 6.9% to around 299 points. The first two days of the next week (28 October and 29 October) saw the Dow fall to 230 points. By 13 November, the stock market was down by a whopping 48% to around 199 points from its high of 381 points, in early September. Fisher lost a fortune in the crash."

“Oh my, stock prices fell by half in a little over two months."

“Yes, they did."

“This must have been devastating for the economy."

“It was. But not just because of the stock market crash," she explained.

“Meaning?" he asked.

“One of the first things that happened after the crash was that New York bankers tried to halt the declining stock market. In doing so, they reduced loans to commodity dealers. This meant that if commodity dealers operating in New York were unable to borrow, they could not buy commodities."

“What happened because of that?"

“With no credit available to the commodity dealers, the prices of commodities such as coffee, rubber, hides, silk and tin, which depended on loans being available in New York, started to collapse."

“And this is how the economic crisis spread."

“Yes. In fact, as the economic historian Charles Kindleberger put it, ‘This spread the financial crisis to the commodity markets … the waves rippled around the world…If the price of a commodity falls, it falls everywhere,’ he explained."

“It’s so interesting to know how things eventually link up," he remarked philosophically.

“The fall of the stock market would not have hurt a substantial portion of the American population, but the fall in commodity prices started to hurt the population at large, given that nearly one in four Americans depended on agriculture at that point of time. This eventually led to the economy contracting and huge unemployment."

“The Great Depression that is."

“Yes."

Friedman and easy money

“But how is all this linked to Sensex crossing the 60,000 level again?"

“Hold on!"

“Okay."

“The Great Depression inspired many Americans to study economics. Milton Friedman was one such individual. In 1963, Milton Friedman wrote A Monetary History of the United States, 1867–1960 with Anna J. Schwartz. This book also featured a revisionist history of the Great Depression. Friedman and Schwartz argued that the Federal Reserve system ensured that a mere stock market crash became the Great Depression."

“And what was their logic?" he asked.

“Between 1929 and 1933, more than 7,500 banks with deposits amounting to nearly $5.7 billion shut down. This, according to Friedman and Schwartz, led to the total amount of currency in circulation and demand deposits at banks plunging by a third."

“So?"

“If the Federal Reserve had pumped more money into the banking system, enough confidence would have been created among the depositors who had lost their money and the Great Depression could have been avoided. With banks going bankrupt, depositors’ money was either stuck or permanently lost to them. Under this situation, they cut down further on expenditure to try and build their savings. This impacted economic activity, given that one man’s spending is another man’s income."

“But I still don’t get what has this got to do with the Sensex rallying again."

“You know, the British economist John Maynard Keynes once remarked: ‘Practical men who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.’ Most economists are also like practical men. Friedman’s thoughts on the Great Depression have dominated the American economic establishment since he first made them six decades back."

“You are confusing me even more now!" he exclaimed, with both his hands in the air.

“American central bankers have been hugely influenced by Friedman’s thinking over the years. This includes Ben Bernanke, who was the chairman of the Federal Reserve when the financial crisis broke out in 2008," she explained, ignoring his barb.

“Okay."

“In fact, at Friedman’s 90th birthday celebrations in 2002, Bernanke, who was a Federal Reserve governor at that point of time, said: ‘I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.’"

“Hmmm."

“As Bernanke wrote in the Essays on the Great Depression: ‘There is… overwhelming evidence that the main factor depressing aggregate demand was a worldwide contraction in world money supplies.’ Or as he said in a 2002 speech: ‘The correct interpretation… is not a popular one–that the stock market got overvalued, crashed, and caused a Great Depression. The true story is that monetary policy tried overzealously to stop the rise in stock prices.’"

“How does all this link up?"

“So, for American central bankers, the Great Depression was the biggest economic event of the last century. And in their heads, while deciding on monetary policy, they are trying to avoid the next big recession, if not a depression. Like when the financial crisis started in 2008, they flooded the system with money. Before that, when the dotcom bubble burst in 2000, interest rates were cut rapidly. In 2020, once the covid pandemic broke out, the Fed printed money and flooded the financial system with it."

“Why do they do that?" he asked.

“The idea is to drive down both long-term and short-term interest rates and get people and firms to borrow and spend money, in order to revive economic activity and prevent a recession."

“Okay."

The market’s bets

“Now, the American economy contracted by 1.6% during the period January to March and by 0.9% during April to June. So, technically, it’s already in a recession."

“And?"

“The stock market is betting that sooner or later the Fed will have to reverse its current policy and go back to the easy money policy. Because with the current policy of raising interest rates, the Fed will end up engineering a much bigger recession. And given the past evidence, this is something that the Fed does not do," she explained.

“Ah, now it makes sense," he remarked.

“Other than raising the short-term interest rates, the Fed has stated that by June 2023, it will take out close to a trillion dollars of money that it had printed and pumped into the financial system. This will drive up long-term interest rates, control demand, and in the process, control inflation."

“Okay."

“The trouble is that data suggests that this is happening at a snail’s pace, leading the stock market investors to bet against what the Fed is actually saying. In fact, in July, the retail inflation in the US had stood at 8.5%, way higher than the levels that Americans are used to and what the Fed likes."

“So, what will happen?" he asked.

“I wish I could give you a straightforward answer for that."

“Give me a complicated one then."

“The Fed, in its public communication, has clearly stated that it will keep raising interest rates until it is able to control inflation. But the market is betting on the Fed going back to the policy of easy money. And this has led to the FII money flooding into Indian stocks all over again and the market touching the 60,000 level again. The question is will this last?"

As soon as she finished saying this, Billy Joel’s song began streaming: “I want the easy easy money easy money".

While Springsteen’s song is clearly better, Joel’s song still captures the spirit of the times that we live in.

And she was left wondering if romance really exists outside books and movies.

(The example is hypothetical)

Vivek Kaul is an economic commentator and a writer.

Elsewhere in Mint

In Opinion, Manu Joseph argues why science is disappointing in comparison to its own reputation. Ashish Dhawan tells why Indian philanthropy is now poised to take off. Anirudh Suri writes what America’s Inflation Reduction Act means for India. 

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