Fenil's Library

This idea to increase the money supply byprinting money is the Single Stupidest Idea in the whole history of economics for the last 4,500 years.

—Richard Daughty 

“You know what? Ben Bernanke, the chairman of the Federal Reserve of the United States, the US central bank, is running up the printing press again,” she said walking into my house, and making herself comfortable on the sofa. 

My new neighbour was getting rather bold, I thought but decided not to be discourteous.

“Yeah, I read it in the papers last week,” I said. “The plan is to print $1.15 trillion and spend that money in various ways, hoping to revive the US economy.” 

“That is so, so stupid, I think. What do you say?” she asked.

I couldn’t hold my angst any longer. “Yeah, it’s stupid. But couldn’t discuss this another time? I was about to take my Sunday afternoon nap.” 

“Oh, come on. This Sunday you can spend some time with me. OK, now tell me about this new plan in a little more detail.” 

“OK,” I relented. “Of the $1.15 trillion that the Fed plans to print, $300 billion is to be used to buy back the debt issued by the US government. The idea is to buy back the securities, so that banks have money which they can go out and lend. But the bigger point is that the government is also extinguishing its own debt. Typically, when we take a loan, we have to earn to be able to repay that money. But a government can print money to repay a loan. And that is what the plan seems to be. This is clearly not a healthy trend, given that the US owes the world around $54 trillion, and this number is growing. Printing money can cause its own problems. Still, the US doesn’t quite have another way out.”

“Why do you say that?” 

“Well, after years of negative savings, the Americans are saving now. The current savings rate stands at 3% of the gross domestic product (GDP) of $14 trillion, which works out to $420billion. In the years to come, the savings rate is expected to go up to 10% of the GDP, thehistorical rate of saving in the US, but the GDP is likely to contract, as people lose jobs andincomes decline. Thus, in absolute terms, the savings are not going to be very different from what they currently are. Hence, if the US saves $420 billion a year and uses all of it to repay debt, even after 10 years, it would have repaid only $4.2 trillion, and this after we assume that the overall debt does not go up. That’s why I think the US has no other way to repay its debt than printing dollars.”

“Interesting. But that was an explanation for only $300 billion. What of the rest?” 

“Of the remaining money, $750 billion willbe used to buy up mortgage backed securities (MBS) issued by housing-related government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac.” 

“What is a mortgage backed security?” she butted in. 

“Banks first give out home loans, also called mortgages in the US. Then they agglomeratesimilar loans and convert them into financialsecurities. These financial securities are sold to investors willing to buy them. Once the securities are sold, the major part of the equated monthly instalment (EMI) that the borrower pays to repay the home loan is passed on to investors who have bought the financialsecurities. This entire process is referred to as securitisation. Once a bank sells these securities, the risk does not remain on its books. Also, the money comes back immediately and the bank can give out more loans.” 

“But where do these GSEs come in?” 

“See, most banks do not have the wherewithal to conduct the entire process of securitisation themselves. So GSEs like Fannie Mae and Freddie Mac used to buy out entire loans from these banks. They would then issue securities against these loans and sell them to investors. But that was in the good old days when the buyers repaid. After a point when the defaults started, the GSEs were no longer in a position to keep buying loans and securitising them.” 

“And what did that do to the market?”

“It killed the securitisation market. Once GSEs stopped buying loans to securitise them, banks realised that they would have to continue to hold loans on their own books. And they did not want to take that risk. That in turn killed the home loan market. Now, with this move of buying up $750 billion worth of GSE-backed MBS, the US Fed is hoping to revive the home loan market.” 

“I didn’t quite get that.” 

“See, the Fed is essentially telling the GSEs to buy out home loans from banks and securitise them, with an assurance that it will buy those securities. The US Fed is now getting into the home loan business, big time. This could push banks to lend again, so the GSEs can buy out these loans, securitise them and sell them to the US Fed. Also once the lending starts to happen again, housing prices might stabilise and even start to go up,” I explained. 

“But why is the US Fed trying to get home prices up and running again?”

“The US consumer was using his home as an ATM machine by taking home equity loans. Home equity is essentially the difference between the market value of your house and the portion of the home loan taken to buy it, which is still to be repaid. So let us say the current market value of a house is $250,000 and the home loan to be repaid is $200,000, the home equity works out $50,000. The loan taken against this $50,000 is a home equity loan. As prices went up, borrowers encashed their homes big time and went on a spending spree. This inspired other buyers to take on loans much greater than their repayment capacity, hoping to cash in. Now, this could only go on till the housing prices were going up. Once the house prices started to crash, the home could no longer be used as an ATM. And once that happened, all the frenzied spending that the US consumer was indulging in came to an absolute standstill. Now, by trying to get the securitisation market going again, the hope is banks will start lending again and people will start borrowing again.” 

“But isn’t that ironical, given that it was excess borrowing that caused the problem in the first place?” she asked. 

“Yes it is. But that’s the way it is. Also, right now, the consumer is not buying the borrowing argument. Also, the $1.15 trillion that the Fed plans to print and spend is other than the $11.7 trillion it has already flushed into the system to rescue the American financial system. I am amazed that even with such an astonishingly high amount of money being printed, there has been no inflation. But in the days to come, inflation is bound to show up as the money starts to hit the system. In that situation, it will be interesting to see how the system holds up. You know, a ten year debt security issued by the US government currently pays a return of around 2.5%. Inflation on the other hand stands at 0.4%. So, basically, the real return is around 2.1%. Imagine if inflation were to hit 5%, which is possible given the amount of money hitting the economy. Investors will simply want to get out of the US government securities, because effective returns will get negative. Then they will get out of the dollar and the dollar will fall against other currencies.”

“Pretty scary, eh,” she said. “Now, if you don’t mind, I will go take my Sunday afternoon nap.” 

(The example is hypothetical) 

k_vivek@dnaindia.net