The next meeting of the Federal Open Markets Committee (FOMC) is scheduled for 16-17 September, and is probably one of the most keenly awaited meetings in recent times. Though the chances of a rate hike have come down according to most market observers, the possible outcomes range between no hike and a 25 basis points increase. Very few are even considering a new round of QE (quantitative easing). I think that’s the most probable outcome.
Why so? Scholars of the Austrian school of economics have long insisted that a boom induced by artificially cheap credit cannot have a happy/orderly ending. Yet, each of the last three chairmen of the Fed presided over ultra loose monetary policies with impunity. It started with Alan Greenspan, followed by Ben Bernanke and now Janet "ZIRP" Yellen era. (ZIRP is short for a zero-interest rate policy).
Of course, the word "with impunity" will be dismissed by the "U6 unemployed" (the US unemployment count that includes the unemployed, those who have quit looking for jobs, and part-time workers). U6 is still in double digits after nearly seven years of a supposed recovery. The labour force participation rate in the US today is at its lowest level in three decades. For all practical purposes, the US economy has been in terminal decline since the housing bust in 2008 and what has masked this decline is an overdose of asset-price stimulus and sleight of hand statistical reporting. This treatment by stimulus has been long drawn-out, but what hasn’t happened till now is the inevitable payment of the bills incurred.
We need, at this point, to elaborate on ZIRP. While it's comrade Ben Bernanke who instituted ZIRP, it is quite likely that Janet Yellen will be the first Fed Chair who completes an entire tenure at or near ZIRP. Forget the oncoming September meeting or any subsequent one, the US economic condition isn’t even close to meeting the criteria set as the bar for rising interest rates. And on the current policy regime, that goal will remain a mirage. Seemingly close, but never quite there.
Not that we ever believed in the efficacy of ZIRP. Or for that matter even in the power of central banks to set interest rates to “guide” the economy. One can also question, at a more basic level, the very concept of central banks over-riding the price mechanism. While we are on this thread, one must mention one’s disdain with the idea of the government’s power to “issue currency and control its quantity and price”. Monetary policy has to be an entirely “free market” function and we are close to realising the folly of entrusting the same to governments. This grand 45-year-old experiment in fiat money (since Richard Nixon closed the gold window on 15 August 1971) can end in only one way - i.e., through the “Crack-Up Boom”.
Ludwig von Mises, an Austrian School economist, defined the Crack-Up Boom as the breakdown of the exchange economy (more at www.mises.org) due to the malinvestments induced by easy credit. This is a long-drawn-out process, often stretching over decades, and usually ends with hyperinflation. Venezuela is currently undergoing one while other recent examples would include Turkey and Argentina.
Back to our thesis: This artificial credit-induced boom of the later 1990s and the early 2000s ended with the housing bust. But instead of allowing for a liquidation of mispriced assets, all that the central banks did was to reflate – ie, they replaced the housing bubble with a bond bubble. Given the precarious nature of government debt (US national debt is at $18.6 trillion) today, any rise in interest rates would set off alarm bells in the currency and bond markets worldwide. The Paul Volcker medicine of the 1980s – where he drove interest rates higher to rein in inflation - cannot be repeated today for precisely this reason.
At a nominal 5 percent interest rate in the US (which is close to the average of the preceding three decades), the US fiscal condition would be similar to that of Greece. So too is the condition of Japan, UK and most eurozone countries. What has kept the treasury bubble from blowing up with devastating consequences is ZIRP - and QE. Yellen certainly wouldn’t want to bring to light the point that the “World is Greece”.
How will it unfold?
The problem with predicting the future is the timelines along with which it could happen. A lot depends on the confidence with which billions of citizens hold onto to pieces of paper, or digits in their bank accounts, thinking all of it is money. Can the central banks sustain this misplaced confidence for another five years? It would be a miracle of sorts, but who knows anything for certain about the future.
But what is likely to happen in the near term is the equivalent of a QE-4 in the US. All talk of increasing rates would be replaced by how low the inflation is and how the US/World economy has not attained “escape velocity” as yet. So Yellen will usher in her own form of monetary stimulus. Whether she calls it QE4 or decides to replace it with a fancier phrase we will know shortly when the masses have to be told that she is trying “something different”. But the form and substance of her actions would be no different – greater monetary stimulus to maintain ZIRP and asset prices in the capital markets. Extend and Pretend.
My guess at this point is that we will witness these experiments in ever looser monetary policies that could continue for another year or two. What gives, or what breaks this trend, would be hard to predict, but one such condition would be the announcement of a gold backed currency by either China or Russia. By all accounts, both these countries’ central banks have been accumulating gold in large quantities, and should in the near future be in a position to do so.
What should India do?
Despite my criticisms of Raghuram Rajan (almost all criticisms directed at him say that he is "too hawkish"; I have criticised him for not being hawkish enough and for not being free markets-oriented), he is one of the best things that could have happened to India. Of course, I would have preferred a variety of changes – looking at money supply growth, which is a leading indicator, and not CPI, which is a lagged index, and possibly one that can be manipulated. Also, the CPI target should have been 0-2 percent and not 4-6 percent. But one can quite sympathise with the situation he is in. The Indian political class, having been used to an entirely pliant and sub-servient central bankers previously, would not have been easy for Rajan to stand up to. But he has truly done it in style.
The biggest surprise for Raghuram Rajan is going to come on the currency front. Sooner or later, when the world transitions to some form of gold standard, India would have the unique opportunity of transitioning to a classical gold standard. Till this point, Rajan has been ambivalent about gold – that is, not decrying that it’s a wasteful investment, like almost everyone does, but also not accepting that gold is money and that currencies are “intrinsically worthless” unless backed by money. I don’t think he is obfuscating on purpose, but time will tell. Either way, I hope he learns soon enough.
The FM’s role is a lot more difficult simply because of his lack of understanding of the situation. All that stands out in his speeches is a clamour for rate cuts. If Rajan had actually obliged him, Jaitley’s situation today would be similar to that of P Chidambaram’s a few years ago. Raghuram has done more to help this economy than Jaitley can possibly understand and Modi should truly thank him for the positive changes happening in the economy.
If Rajan can be cloned and shifted in as finance minister, it would do India a world of good. But given that it can’t be done and Modi, for reasons best known to him, seems to persist with Jaitley, the best hope is that Jaitley pushes ahead with an agenda of cleaning up the excessive regulatory and deficit regime left behind by UPA and devolving greater power and autonomy to state governments. (For the record, replacing Jaitley with someone like Subramanian Swamy would be retrograde. Jaitley at least knows that he doesn’t understand economics well enough and sticks to the basics. In comparison, Swamy would be a Paul Krugman on steroids),
Of course, given the critical world economic situation, moving towards a system of limited government and balanced budgets would be ideal. That would be one real stimulus that India has been waiting for since independence.
About the author
Shanmuganathan "Shan" Nagasundaram is the founding director of Benchmark Advisory Services – an economic consulting firm. He is also the India Economist for the World Money Analyst, a monthly publication of Mauldin Economics. He can be contacted at firstname.lastname@example.org
Updated Date: Sep 04, 2015 16:10 PM