The Path Less Trodden : From Friedman to Greenspan



The preferred macro-economic model across the world right now has become the use of Monetary Policy, rather than the FISC, to push growth by lowering the cost of money. This is based on the assumption that debt-fuelled investment (in the emerging markets) and consumption (in the developed markets), will be able to pick up the slack, REGARDLESS of the reason for the decline.

Declaimer: This article was originally in December 2016, and some of the data points may be outdated

This worked okay in cyclical downturns but has failed in the case of the Balance Sheet recession (a.k.a. credit recession), where the sensitivity of debt offtake to lower interest rates, has slackened, and in some cases, has even turned negative.

This is the equivalent of a bartender who presents a friendly face at the bar, over the first 2 drinks, but should turn ugly by the time you are on your 12th. He should now be worried about the drunkard’s aggression and his ability to pay.

Instead, imagine the bartender who is hoping to revive his somnolent customer, on his 12th peg, with another 2 pegs, and then maybe 3 further. We must be at the monetary equivalent of the 28th peg in Japan, the 15th in the US, and the 12th in Europe. Why would Central Banks be pushing on a string, going to the extent of kicking the moribund customer to get him to down a few more? This metaphor is most appropriate to explain the current NIRP regime.

How did it get like this? Economics started as Moral Philosophy and Adam Smith’s doctrine tried to lay out the 10 Commandments of good economic behavior. A good look at his writings would set him out to be the first behavioral economist, who like Moses, distilled philosophy into simple commandments.

Cut to Keynes, who spectacularly prescribed an antidote for the Great Depression, “dig holes and fill them”, i.e. focus on employment and put money in the hands of people so they can consume. The resulting upward spiral came on the back of healthy Balance Sheets, helped along by a big war, that created genuine demand for investment. The same prescription, applied with a knee-jerk in the Great Recession some 75 years later, had decidedly different results.

Adam Smith’s philosophy was taken up by the Austrian economists, who made their Economics into a kind of Moral Science for one (economic) aspect of human behavior. They did not realize that their prescription of “upfront the pain, backend the gain” went against the basic human spirit. So even though the ‘science’ was theoretically and philosophically robust, it had few takers. “Being right is not the same thing as being effective”, they learned as they lost dominance to the Chicago school.

The Chicago school meanwhile took center stage with the rise of America in the background, and the pre-eminence given to hedonism in all American choices thereafter, as the Baby Boomers took over. Was it a coincidence that the Great Recession hit, just as the Boomers were retiring?

The last years were presided by the reining deity, who happened to sit at the Fed, Alan Greenspan, the man who famously “couldn’t see a bubble, until after the fact”. In Adam Smith’s lingo, he couldn’t see the bingeing while it was happening, he could only come in to clean up after the brawling was over. He surrendered the role of the bartender and turned into the charwoman, who only came in the next morning.

The economic establishment in general, and the US in particular, started to choose the hedonic option again and again, until it became culture. Worse, with its dominance over Economics, it changed the models to reflect this bias. The Austrians, who stuck with choosing the difficult (but less trodden) option, quickly lost relevance.

Greenspan’s easy money reduced the cost of money, hurting savers in general and the idea of thrift itself. Incentives were biased now, to reward those who lived on borrowed money, especially the spreads on other people’s money. This created the 1%, who made money off the savings of the 99%, creating the biggest wealth transfer in history in the space of half a generation. America is today one of the most unequal societies in the world, with Gini co-efficient at levels where African dictatorships used to be in the 70’s.

Asset markets rose on the back of asset inflation, created by the cheap Fed-created money. This favoured the Financial Services industry in particular, and the 1% in general. At one time, financial services and related activities (housing mortgages, for example) accounted for 23% of American GDP, twice the anyway-crazy 12% commanded by healthcare.

No developed country dares to get off this tiger now. The cost of reversing this policy is so high, that nobody will survive a reversion to even the mean, let alone a swing to the other way (a.k.a. austerity).

India saw a variant of the same policy. The Congress years, which coincided with the Greenspan years worldwide, saw a huge steroidal uptick in GDP numbers, which came from the flood of money supply gushing out of the US (and later, Europe). If you could put a number to this, i.e., that an economy gets an increase in sentiment, rather like the sudden roses that appear after the 3rd drink, then that number is the increase in the velocity of money. It peaked around 5 in the US and has been falling continuously thereafter.

In lesser form, India went through its exuberance, which has abated quite a bit. What has been noticed is that this cheap money gets concentrated around the financial economy, it pushes up asset inflation but percolates down to the real economy over some time. During this time, the people on Wall Street got richer, starting with the bankers. This time, the party was over before the trickle-down could get underway, and there was this huge deflationary bust (in asset markets), which had to be picked by the Govt and transferred to the real economy in the form of higher Fiscal deficits, which is supposed to (over time) flow through to inflation.

However, the falling velocity of money in the US has taken off the inflationary pressures, and they have chosen, monkey-like, to take the softer (immoral, in terms of the Austrian lexicon) option of trying to bail their way out by printing more money. Steep as this money-printing has been, it has not been as steep as the fall in the velocity of money, which has kept a lid on inflation.

In India, the “wealth effect” was created as the first beneficiaries of this wave of new money, were the exporters, robber barons, and the people on, well, Dalal Street. This has taken our Gini coefficient to slightly below US levels. The consumption effect of this Wealth Effect did trickle down somewhat, leading to real GDP growth, but jobs did not follow apace. Hence, we had this combined appearance of a high Current Account Deficit, few jobs, and high GDP growth. An insular mainstream media did not allow anyone to see this, with nobody bothering about the commoners outside the party hall.

It is in this context that we have to understand the current campaign of redistributive justice that is being attempted by the Govt, starting first with bringing about a culture of higher tax compliance. Demonetisation is just the first step, which stirred up the snake pit, but the long-term impact of a series of other measures will be an increase in the tax: GDP ratio. This will roughly equal the current Fiscal Deficit, effectively neutralizing it. If the Govt chooses to put all this new money into fixed capital, it will increase the productive capacity of the economy by roughly 30%. This new GDP will go to the poorer half, leading to a large uptick in domestic savings, which will neutralize the CAD.

Given that this redistribution is disintermediated from Dalal Street, there will be no bubbles, because asset markets will follow product markets rather than the other way round. The Wealth Effect will be reversed because the economic growth will be bottom up rather than the previous trickle-down from the top. It will be unique in the current world economy, the only place in the world where new money is being put into the hands of the poor rather than the 1%. Markets will discount this only when the resultant savings flow through into stocks, rather than discounting expected (but not forthcoming) earnings too far into the future



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