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Economy Sep 19, 2013

Why US Federal Reserve wants to continue blowing bubbles

By Vivek Kaul

The decision of the Federal Reserve of United States to continue printing money to revive the American economy has gone against what most experts and analysts had been predicting. The Federal Reserve had also been saying that it plans to start going slow on money printing sooner, rather than later. But that hasn't turned out to be the case. So what happened there?

When in doubt I like to quote John Maynard Keynes. As Keynes once said "Both when they are right and when they are wrong, the ideas of economists and political philosophers are more powerful than is commonly understood. Indeed, the world is ruled by little else."

The current generation of economists in the United States and other parts of the world are heavily influenced by Milton Friedman and his thinking on the Great Depression.

Ben Bernanke, the current Chairman of the Federal Reserve of United States is no exception to this. He is acknowledged as one of the leading experts of the world on the Great Depression that hit the United States in 1929 and then spread to other parts of the world.

The decision of the Federal Reserve of United States to continue printing money to revive the American economy has gone against what most experts and analysts had been predicting. AP

The decision of the Federal Reserve of United States to continue printing money to revive the American economy has gone against what most experts and analysts had been predicting. AP

In 1963, Milton Friedman along with Anna J. Schwartz, wrote A Monetary History of United States, 1867-1960. What Friedman and Schwartz basically argued was that the Federal Reserve System ensured that what was just a stock market crash became the Great Depression.

Between 1929 and 1933 more than 7,500 banks with deposits amounting to nearly $5.7billion went bankrupt. With banks going bankrupt, the depositor's money was either stuck or totally gone. Under this situation, they cut down on their expenditure further, to try and build their savings again.
If the Federal Reserve had pumped more money into the banking system at that point of time, enough confidence would have been created among the depositors who had lost their money and the Great Depression could have been avoided.

This thinking on the Great Depression came to dominate the American economic establishment over the years. In fact, such has been Friedman's influence on the prevailing economic thinking that Ben Bernanke said the following at a conference to mark the ninetieth birthday celebrations of Friedman in 2002.

"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."

At that point of time Bernanke was a member of the board of governors of the Federal Reserve System. What Bernanke was effectively saying was that in the days and years to come, at the slightest sign of trouble, the Federal Reserve of United States would flood the financial system with money, as Friedman had suggested. That is precisely what Bernanke and the American government did once the financial crisis broke out in late 2008. And they have continued to do so ever since. Hence, their decision to continue with it shouldn't come as a surprise because by doing what they are, the thinking is that they are trying avoid another Great Depression like situation.

Currently, the Federal Reserve prints $85 billion every month. It pumps this money into the financial system by buying government bonds and mortgage backed securities. The idea is that by flooding the financial system with money, the Federal Reserve will ensure that interest rates will continue to remain low. And at lower interest rates people are more likely to borrow and spend. When people spend more money, businesses are likely to benefit and this will help economic growth.
The risk is that with so much money going around in the financial system, it could lead to high inflation, as history has shown time and again. To guard against this risk the Federal Reserve has been talking about slowing down its money printing (or what it calls tapering) in the days to come.

Ben Bernanke, the Chairman of the Federal Reserve, first hinted about it in a testimony to the Joint Economic Committee of the American Congress on May 23, 2013.

As he said "if we see continued improvement and we have confidence that that is going to be sustained, then we could in - in the next few meetings - we could take a step down in our pace of purchases." As explained earlier, the Federal Reserve puts money into the financial system by buying bonds (or what Bernanke calls purchases in the above statement).

Bernanke had hinted at the same again while speaking to the media on June 19, 2013, "If the incoming data are broadly consistent with this forecast, the Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year...And if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around mid-year."

Given this, the market was expecting that the Federal Reserve will start to go slow on money printing, sooner rather than later. But that hasn't happened. The consensus was that the Federal Reserve will start by cutting down around $10 billion of money printing i.e. reduce the money it prints every month to around $75 billion from the current $85 billion.

So why has the Federal Reserve decided to continue to print as much money as it had in the past, despite hinting against it in the past?

Bernanke in a press conference yesterday said that conditions in the job market where still far from the Federal Reserve would like to see. The Federal Reserve was also concerned that if it goes slow on money printing it could have the effect of slowing growth. "In light of these uncertainties, the committee decided to await more evidence that the recovery's progress will be sustained before adjusting the pace of asset purchases," Bernanke said.

Let's try and understand this in a little more detail. Federal Reserve's one big bet to get the American economy up and running again has been in trying to revive the real estate sector which has suffered big time in the aftermath of the financial crisis.

This is one of the major reasons why the Federal Reserve has been printing money to keep interest rates low. But home loan(or mortgages as they are called in the US) interest rates have been going up since Bernanke talked about going slow on money printing. As the CS Monitor points out "Since Fed Chairman Ben Bernanke first mentioned the possibility of scaling back the Fed's purchases this past June, the average rate for a 30-year fixed rate mortgage has surged over 100 basis points -sitting at 4.6 percent as of last week - and certain market indicators are showing signs of slowdown." This has led to the number of applications for home loans falling in recent weeks. Also, as interest rates have gone up some have EMIs.

As an article in the USA Today points out "after a mere hint of new policy spiked mortgage rates enough to add $120 a month, or 16%, to the monthly payment on the median-priced U.S. House."

Higher interest rates leading to higher EMIs on home loans, obviously jeopardises the entire idea of trying to revive the real estate sector. New home sales in the United States dropped 13% in July. And this doesn't help job creation. As the USA Today points out "At more than 4 jobs per new single-family home, that means a normal recovery in housing - not a 2005-like bubble - would add 3 million jobs...Moody's Analytics says. Quick arithmetic tells you that 3 million new jobs would take 1.9 percentage points off the unemployment rate."

And that is the real reason why the Federal Reserve has decided to continue printing $85 billion every month. Of course, one side effect of this is that a lot of this money will find its way into financial and other asset markets all around the world.

Investors addicted to "easy money" will continue to borrow money available at very low interest rates and invest in financial and other markets around the world. So the big bubbles will only get bigger. As economist Bill Bonner writes in a recent column "Works of art are selling for astronomical prices. High-end palaces and antique cars are setting new records. Is this reckless money hitting the stock market too?"

Or as a global fund manager told me recently "If you look at Sotheby's and Christie's, in the art market, they are doing extremely well. The same is true about the property market. Prices have gone up to $100,000 in places which are in the middle of a jungle in Africa. Why? There is no communication. No power lines there."

The answer is very simple. The "easy money" being provided by the Federal Reserve will continue showing up in all kinds of places.

(Vivek Kaul is a writer. He tweets @kaul_vivek)

by Vivek Kaul

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