Fenil's Library

Governments will keep the press running to finance at least some portion of the fiscal deficit, as rising interest rates are not politically expedient

Vivek Kaul. Mumbai

It was one of those mornings. It had rained all night. There were puddles of water everywhere. The red gulmohar tree was in all its glory. And I woke up to a smell of strong filter coffee and a bright smiling face.

“I am confused,” she said.

“What’s new about that?” I retorted. “You are confused all the time.”

“Arre, I am not confused about us. But about something else.”

“Oh. Something else! And what is that something else?”

“Inflation and deflation.”

“But what is there to be confused about? Inflation is a situation when prices are rising and deflation is a situation where prices are falling,” I explained.

“V, having lived with you all these months, I know that much.”

“Then?”

“What I am unable to comprehend is that almost every big economy in the world is resorting to currency printing in an unprecedented way, something the world has not seen before. Conventional economic theory, as you have explained to me time and again, suggests that more money chasing the same number of goods leads to an increase in prices, and thus inflation. With all the currency that is being printed, the world should have been in the midst of hyperinflation by now,” she said, explaining her predicament.

“Do you understand the term velocity of money?”

“Oh. Physics in economics?”

“Yeah, physics in economics. Let us say a government prints $1 trillion and keeps it in its vaults. How much impact would this money printing have on inflation or price rise?”

“Zero impact,” she replied.

“Correct. Simply because all the printed money is in the vault and does not enter the economic system. Only when this money enters the economic system will it lead to a situation where in more money chases the same or even fewer goods, leading to a price rise. At the same time, it is important how fast does this money change hands, meaning how fast people receive and then go out and spend this money. The faster they spend this money, the more velocity money has and that, in turn, leads to a faster increase in prices and thus inflation.”

“Hmmm. So the question is why isn’t the money entering the system?” she asked.

“How does the printed money enter any economic system? I mean, no government prints money and then goes around dropping it down from a helicopter. Do they?”

“Stop being sarcastic. The money being printed enters any economic system through the banking system in any country.”

“Exactly. Now, take the case of United States of America. Commercial bank loans have gone down over a period of the last one, three, six and nine months. What does that tell you? As one economic commentator put it, ‘the bubble of trust has been broken’. Banks are no longer sure that what they lend will be repaid. So, it is better for them not to lend now, rather than be sorry later. Other than this, nearly 52 banks have closed down in the US and so have more than 300 home loan companies or mortgage finance institutions as they are called in the US. What does this do? The money remains in the vault, leading to a low velocity and thus, a situation where prices are not rising, but falling. In fact, the rate of inflation — or deflation, as we should call it, in the US right now is a negative 1.4%.”

“Is that the only reason for a low velocity of money?” she asked.

“In economics, there is never only one reason for anything. The other main reason for the low velocity of money is the fact that people are not spending it. In June, the U6 unemployment rate, which is the broadest measure the US has for measuring unemployment, reached an all-time high of 16.5%. This means one in six individuals has lost his or her job. In such an environment, people are obviously not going to go around spending the money they have. This again leads to a lower velocity and thus, no rise in prices despite the currency printing. Also, in an environment of such uncertainty, the rate of saving has shot up to around 5% of the gross domestic product from a near zero rate. People now realise they have huge debts to pay off and need to save money. Again, when people save, the velocity of money goes down, leading to a situation of constant prices or decrease in prices. The savings rate is only likely to increase in the days to come as people continue to save more. As they continue to save more, it implies they are highly unlikely to borrow money to spend as they had in the past. This in turn means velocity of money will continue to be low for sometime, and so inflation is not a threat for sometime at least,” I explained.

“But will the currency printing continue?”

“Yup, it will for some time. Governments, as I have told you, usually spend much more than what they earn. To make up the difference, they borrow. When they borrow, their outstanding debt goes up. As of end 2008, the US government debt stood at 41% of the GDP. This is expected to go up to anywhere between 71-80% of GDP over the next four years and around 100% of GDP over the next 8-10 years. This is a figure put out of the congressional budget office of the US. Now, it is highly likely the debt goes up at a much faster pace, given that tax revenues are slowing down big time. The US government’s tax revenues for April, which is the biggest revenue month, were down 34%. So the government will have to borrow much more than it is projected to borrow. And when that happens, the interest rates are likely go up, given that domestic as well as foreign investors may want a greater incentive to invest in debt issued by the US government. Rising interest rates is not a politically expedient scenario, given that US citizens have huge loans to pay off, as increasing interest rates will mean higher EMIs. So the easiest thing for the government to do is print currency to finance some portion of the fiscal deficit, instead of going out and borrowing the entire amount. And so the currency printing is likely to continue in the days to come.”

“Interesting. Anything else?”

“Some extensive research has been carried out on the topic of government spending and it clearly suggests that for every one dollar increase in government spending, private spending reduces by one dollar. In some periods, government spending does improve economic performance, but in other periods, it pulls it down. So net net, there is no impact on the GDP of the country, and at the same time, the government debt increases. This in turn leads to more currency printing to repay the debt. It also leads to increased taxes as the government tries to battle a slowdown in tax revenues as well as pay off its previous debt. One economic study even found that for every one dollar increase in taxes, private spending goes down by three dollars. Scary isn’t it?”

The example is hypothetical)