C3S Paper No. 0177/2015
Courtesy: Business Standard
It is both common and easy to pontificate on what has been wrong, and not right, with public policy after the fact with the benefit of hindsight. But moral legitimacy imperatives demand that foresight be demonstrated at the time of rollout of public policy and not several years later by which time actual outcomes, as opposed to intended policy outcomes, become widely known. At least the author and Prof Lawrence Summers, former US Treasury Secretary, can claim such legitimacy for while this author in a speech at Chandigarh in 2008 likened the public policy response to the 2007 crisis ‘Financial Meltdown1.0’ to “treating bacterial infection with paracetamol rather than with antibiotics”, Summers, a week later in Canada, likened it “to treating viral infection with antibiotics”!
The world is into eighth year since the last apocalyptic and cataclysmic global financial meltdown and the resulting Great Recession. The recovery in the US, Eurozone and Japan, which between them account for 46 % of the current world GDP, continues to remain severely anaemic as measured on any parameters and metrics. This is despite an unprecedented global deluge of the so-called high powered primary/ base money, what with combined balance sheets of their central banks almost tripling and with that of the US Federal Reserve quintupling.
Specifically, in the past eight years, the US Fed’s balance sheet expanded from $900 billion to $4.5 trillion (400%) and US money supply expanded from $7 trillion to only $12 trillion (71% ); the ECB balance sheet went from $2 trillion to $3 trillion (50%) and money supply from $8 trillion to only $11 trillion (26%); and the Bank of Japan balance sheet from $1 trillion to $3 trillion (200%) and money supply from $ 7 trillion to only $ 9 trillion (29% ).
The sole public policy purpose of this unprecedented, and aggressively steroidal monetary stimulus, alongside near-zero nominal policy interest rates, was its much hoped for efficient and effective transmission to the ‘real sector’ in terms of so much more borrowing by households and businesses for more consumption and investment, in turn, for so much higher output and employment.
But against these much hoped for outcomes, what has been the actual ground reality?
The reality on the ground has, if anything, been a far cry from these intended public policy outcomes. Perversely ,there has indeed been an efficient and effective transmission of monetary policy , not to the ‘real sector’ but, disturbingly, almost entirely, to the ‘financial sector’, what with asset bubbles in stock and bond markets having already inflated much more than in the pre-meltdown period.
Ominously, the US stock market is currently trading at a multiple of 130% to the country’s current nominal GDP compared to pre Meltdown 1.0 of 110% and post Meltdown 1.0 of 62%. Worse , as a direct consequence of three-phase Quantitative Easing, US Treasuries are currently trading at almost twice their pre Meltdown 1.0 valuation with spillover only into stock markets and nothing at all into the real sector as intended and hoped for.
If only to have a chilling and numbing sense of the current overvaluation, another name for Asset Bubble 2.0 , suffice it to say that the Dow Jones, to be ‘fairly’ valued relative to the way too overvalued treasuries, needs to be at 40,000 levels instead of the current 17,500 (This is obtained by dividing stock index earnings of 5% – backed out as the inverse of current PE multiple of 20 – by 10 year US treasury note yield of 2.15 % and multiplying by the current reading of the Dow Jones of 17500 , that is , 5/2.15=2.32*17500 = 40000) .
This post Financial Meltdown 1.0 combination of much larger stock and bond bubbles and anaemic real economy has all the portents of a much worse Financial Meltdown 2.0.
Turning next to the real recovery story of the ‘real sector’, though much is made of the unemployment rate in the U.S. having dropped from 10% in the aftermath of the financial meltdown to 5.3 % now as evidence of significant improvement in labour market conditions, the reality turns out otherwise if one also considers the fact that labour market participation rate at 62.6% is at a 37-year-low.
In other words, since 1978, skilled and working-age Americans actively looking for work are down to this 37-year-low, thanks largely to the recession itself which resulted in huge loss of skills relevant to any meaningful recovery.
Similarly, the latest quarter US GDP rising an annualised 2.3% is no real growth story if one also considers the fact that in the past, during comparable recessionary episodes , growth in real output has been more than twice as large. Another instructive way to reach the same conclusion is to consider that in the last eight years, the US nominal GDP rose from $ 15 trillion to only $18 trillion. So the so-called US recovery, which is creating such hype about imminent exit from the current ultra-loose US monetary policy by way of increase in policy rates, is no real recovery story at all. Of course, it is another matter that the proposed exit sequencing itself, by way of first raising policy rates rather than first shrinking the Fed balance sheet by selling back assets and then only raising policy interest rates, is intellectually and logically flawed.
As regards the recovery story in the euro zone and Japan, no one is even pretending there is any recovery in the first place, what with GDP in the Eurozone and Japan growing currently by an anaemic annualised 1.5% and 1%, respectively, and nominal GDP in the Eurozone declining from $14 trillion to $13.4 trillion and that in Japan stagnating at around $4.5 trillion seven years after the global financial meltdown and Great Recession. In fact, in Japan after the so-called ‘two lost decades’, it almost looks like the ‘third’ is already underway with the Eurozone very likely on course for their ‘first decade’.
Equally, labour market conditions in the Eurozone and Japan are worse with current unemployment rates of 11% and 3.3% with labour force participation rates at 58% and 56 %, respectively. And if only to complete the severely anaemic global recovery story, one may also like to take note of the latest annual inflation rates of only 0.1%, 0.2% and 0.1% in the US, Eurozone and Japan, respectively, as against the policy targets of 2%. So much for the monetarist worldview of ‘inflation being always and everywhere a monetary phenomenon’!
So the question to ask then is where has all this hugely aggressive steroidal deluge of ‘high powered base money’ gone? In other words, whatever became of the so-called efficient and effective monetary transmission to the real sector via the fabled Money Multiplier? The simple common sense, as well as the textbook, explanation is that the so-called fabled Money Multiplier progressively collapsed alongside unprecedented massive expansion in central bank balance sheets and “high powered base money”. In particular, since the financial apocalypse, the money multiplier collapsed from 8.5 to 3.5 in the US, from 10 to 5 in the Eurozone and from 8 to 6 in Japan , in an unmistakable, incontrovertible and conclusive evidence of a dysfunctional monetary transmission.
This collapse in the money multiplier for the ‘real sector’ is graphically and dramatically illustrated by excess reserves held by banks in the US centupling from a mere $27 billion in 2006 to $2.5 trillion currently, representing 3%, and 55%, respectively, of the Fed balance sheet. It is, thus, a no-brainer to see that the so called ” high powered base money ” became both ‘powerless’ and, if you will, ‘baseless’ in spite of near-zero policy rates. This was primarily because households and businesses, paradoxically and counterintuitively, chose to save rather than spend and invest, thus doing almost nothing towards raising aggregate demand in the real economy. This is precisely what also explains banks in the US accumulating, rather than lending to households and businesses, excess reserves with the Federal Reserve.
Thus as noted above , only a net incremental amount of high powered central bank base money of about $1 trillion ( $ 4.5 trillion- $ 2.5 -$ 900 billion) has been efficiently and effectively transmitted but almost entirely to the financial sector comprising stocks and bonds , and almost nothing to the real sector.
This savings syndrome is tellingly reflected in net private savings (the U.S. and Japanese non-bank corporates together sit on a cash pile of $4.5 trillion) as the difference between current account balance and fiscal budget balance in the US, Eurozone and Japan. Specifically, in the last eight years, net private savings increased by 5 % from -5 % of GDP to 0% currently, in the US, whereas in Japan and the Eurozone, they are quite high at 9.2 % and 4.6 % with that in the Eurozone masking way too high net private savings in Germany and the Netherlands of 7% and 11.5%, respectively.
So where the fabled Money Multiplier failed, Keynesian Multiplier would have succeeded back then in double quick time and indeed so it will now as it indeed did in 1937 and in the post-World War II period. We have wasted and lost seven long years since the crisis outside of Japan which was caused by monetary policy in the first place.
Economic history bears out that so far all major economic crises had their genesis in irresponsible and wayward fiscal policies but never before until 2007 was it caused by monetary policy and on such unprecedented and devastating scale. So the public policy response of choice should been Keynesian and, not monetarist, because while monetary stimulus can create ‘money’ out of nowhere, it cannot necessarily create ‘income’ and, therefore, demand for money. In contrast, fiscal stimulus can effectively address a dysfunctional monetary transmission by directly creating income and demand for money through more public dis savings (fiscal deficits) in excess of net private savings.
The loss of precious time of close to 8 years since the Financial Meltdown 1.0 , entailing avoidable excruciating misery and social and economic pain, is inexcusable because as Keynes very aptly and succinctly put it: In the long term , we are all dead!
If only the US government had cut taxes and borrowed and spent equivalent to even a part of the current excess reserves of $ 2.5 trillion, it would have not only made such massive expansion of central bank balance sheet unnecessary in the first place, but also made Keynesian Multiplier efficiently and effectively resurrect Money Multiplier to its full potential, resulting in a much quicker and robust economic recovery with monetary policy playing a supplementary role so calibrated that as Money Multiplier resurrected, Keynesian Multiplier got phased out !
In conclusion, the foregoing should not at all be seen as derogating and disparaging Monetarism and extolling the virtues of Keynesianism, but only as a lowdown on the contextual and circumstantial inappropriateness of Monetarism and appropriateness of responsible and activist Keynesianism which the author, in the opening paragraph, alluded to as ‘treating bacterial infection (read the Great Recession) with paracetamol (read monetarist prescription) rather than with antibiotics (read Keynesian prescription)’ The entire public policy response so far is thus best described by paraphrasing Norman Vincent Peale: “We would rather be ruined by policy orthodoxy than be saved by policy heresy!”
(The author is former executive director, Reserve Bank of India)