05 November 2009

'Cheap Money Mischief' False sense of comfort

This is a mail from Suyodh Rao who points to two articles:
The first by Gillian Tett Financial Times  'Rally fuelled by cheap money brings a sense of foreboding'
The second by Roubini also in the FT 'Mother of all carry trades faces an inevitable bust'


The two put together answer some questions as to why asset prices are rising even though things dont 'feel' so good. Companies are reporting decent results no doubt. I have not looked at Market PE Ratios, that will give a better idea whether equities are reasonably or otherwise priced.
The factor that cannot be ignored is where the money that is being pumped in by govts is finally ending up. One chunk of stimulus money obviously went to shore up financial institutions balance sheets. Leftovers of that stimulus will find its way into either consumer prices or asset prices.
What the articles talk about is how the loose monetary policy & the fiscal stimulus of the US are both fueling worldwide asset price inflation. Realty prices world-over are still on the higher side when one compares them to trend-line relationship with incomes. Incomes (real) are down if anything and should push house prices even lower. As for stock prices, one will have to look at PEs.
The current crop of policy-makers seem to have not read their Economic History texts, or have forgotten them. While that may sound like an audacious statement, I take the support of two statements of two individuals (quoted below) who, in most respects, have had the most impact on economic policy-making in the 20th century (and onwards). In the days when these were written, there weren't the fancy hedge and fence funds of today. Nor was the stock market hogging newsprint. That may have allowed them to give Money Supply the respect that was due to it. There were three variables that they focused on - Employment, Output & Price Level. Today the financial sector employs tens of times more folks (percent of workforce), and that has changed the focus of policy. In my opinion, that is an unwelcome change. But then, the counter-tautological statement would be that if the financial sector goes down the drain, then the real sector is doubly hurt. That statement has its merits. But, since the financial sector doesn't matter, let us tinker with it. Therein lies our mistake.

There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose. 
John Maynard Keynes, 1920


My own studies of monetary history have made me extremely sympathetic to the oft-quoted, much reviled and as widely misunderstood, comment by John Stuart Mill. "There cannot ....," he wrote, "be intrinsically a more insignificant thing, in the economy of society, than money; except in the character of a contrivance for sparing time and labour. It is a machine for doing quickly and commodiously, what would be done, though less quickly and commodiously, without it: and like many other kinds of machinery, it only exerts a distinct and independent influence of its own when it gets out of order".


True, money is only a machine, but it is an extraordinarily efficient machine. Without it, we could not have begun to attain the astounding growth in output and level of living we have experienced in the past two centuries - any more than we could have done so without those other marvelous machines that dot our countryside and enable us, for the most part, simply to do more efficiently what could be done without them at much greater cost in labor.

But money has one feature that these other machines do not share. Because it is so pervasive, when it gets out of order, it throws a monkey wrench into the operation of all the other machines. - 
Milton Friedman, 1968


PS The above has been written on the fly, may miss some connections, but seems to make sense. Hope it does the same when it meets the reader's eye :) If my last para above doesn't make sense at first, read the quote of Friedman and then re-read my para.

What I am saying in essence is that Money Supply increases take time to show their impacts. Asset-price inflation and/or consumer price inflation will follow Money Supply increases. Asset prices have to revert to their historical trend-lines and relationships with other economic variables such as income etc. The reversion will be in Real terms, and very likely in Nominal terms too. When that correction comes, it is not going to be pretty. When the economic history of the first decade of the 21st century is written, the rally of 2009 may not occupy more than a square inch.

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