Global economy is facing a Hotel California problem

Photo: AP
Photo: AP


Economic dependence on money creation makes it hard for central banks to reach for policy exits

On 3 November, the US Federal Reserve decided to start ‘tapering’ from later this month. The US Fed’s act of reducing its money printing and buying fewer bonds is referred to as tapering.

The total assets of the US central bank, as of 3 November, stood at $8.57 trillion, the highest that it has ever been. Almost all the expansion of the Fed’s balance sheet has happened post August 2008. In early September 2008, the size of its balance sheet was $905 billion. From there, it kept growing to reach a peak of $4.52 trillion in mid-January 2015. Why did this happen? In mid-September 2008, a big investment bank, Lehman Brothers, went bust. This brought the global financial system to the brink of a collapse and was followed by huge fears of another Great Depression.

Over the years, American economists have come around to the idea that a major reason for the Great Depression that began in 1929 was a lack of money going around the US financial system due to the collapse of many banks.

Hence, eight decades later, the Fed bought Treasury bonds and mortgage backed securities (MBSs) and flooded the financial system with money. Treasury bonds are bonds issued by the American government to finance its fiscal deficit. Further, when banks and financial institutions securitize their mortgages or home loans, the financial securities that emerge from it are referred to as MBSs. The Fed printed money to buy these bonds. In the truest sense of the term, actual money printing doesn’t happen, as money is created digitally. But the process of creating money out of thin air is the equivalent of printing it.

Thanks to its bond-buying, the Fed’s assets in January 2015 were about five times the figure for September 2008. The idea was that with so much more money pumped into the US financial system, interest rates would fall and people would borrow and spend while companies would borrow and expand. This would revive economic activity.

After January 2015, the Fed started shrinking its balance sheet by selling the bonds it had bought and trying to gradually suck out the money it had printed. This continued up to 2019, and by end September 2019, its balance sheet size had shrunk to $3.76 trillion.

In early 2020, the covid pandemic struck and economic activity froze. The Fed went back to its 2008 toolkit, upped its money printing and again started buying bonds. In the process, the Fed’s balance sheet more than doubled in size. In absolute terms it has expanded more post-covid than it did in over a century of its existence before that. It wasn’t just the US central bank that resorted to massive money printing; so did other central banks around the world.

On 3 November, the Federal Reserve announced it would slow its buying of Treasury bonds down by $10 billion per month and that of MBSs by $5 billion per month. If this pace of purchase reduction continues, it is expected that the Fed will stop money printing and bond-buying by June 2022. This is expected to have a wide impact on the global economy.

As the economist Ronald Coase puts it, “All solutions have costs." To which Diane Coyle adds in Cogs and Monsters: What Economics Is, What It Should Be: “A specific policy or regulation may solve one problem but cause others elsewhere… Coase attributed the many examples of government failure to economists’ habit of seeing their job as fixing a problem in a particular context without considering the way behaviour will change as a result."

While money printing was supposed to encourage economic activity by encouraging companies and individuals to borrow more, it also led to investors searching for higher returns and driving up stock prices. Real estate prices have also boomed across large parts of the Western world. Investors in search of higher returns have also driven up commodity prices, everything from oil to coal. And the prices of cryptocurrencies and valuations of unicorns have reached mind-boggling levels. In their search of economic growth, central banks and governments have ended up creating gargantuan financial bubbles.

Tapering will slow down the printing of money, the fuel that feeds bubbles. If the Fed and other central banks are able to continue with it and reach a stage where they can start shrinking their balance sheets by selling the bonds they had bought, the speculative financial economy that has emerged over the last few years will probably take a beating. Prices of stocks, commodities, real estate and cryptocurrencies will all fall. So too will unicorn valuations.

On the other hand, for a country like India, which is heavily dependent on imports of commodities like oil and coal, falling commodity prices would mean good news on some fronts. It could also mean that growing inequalities in our society will get a brief break.

The question is whether the Fed and other central banks will be able to go through with this, or will they chicken out if stock prices fall on a sustained basis. To conclude, as The Eagles first sang in Hotel California (1977): You can check-out any time you like, But you can never leave. Today’s global economy that has grown dependent on money printing by central banks has become a tad like that. It’s easier to just kick the can down the road.

Vivek Kaul is the author of ‘Bad Money’.

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