Business

Monday February 16, 2009

Printing money to boost asset prices?

Hawk's view point - by Choong Huat Hock


It’s a tempting scenario but not one without considerable risks

THE powers that be in the US Federal Reserve and Treasury may be tempted to print money that would boost inflation as a means to boost stock and house prices. Such a rise in house and stock prices would reduce mortgage defaults and improve the balance sheet of banks.

With stronger balance sheets, banks would be more keen to lend while consumers would again be interested in buying assets like houses and stocks as a hedge against rising inflation. Higher inflation would also deflate debt as the nominal value of debt remains the same while asset prices rise. This could be the only way to solve the US debt problem as total US debt standing at US$50 trillion, or 350% of gross domestic product (GDP) is the highest that it has ever been.

Savers will pay the price as bond prices fall due to inflation and the US dollar depreciates. Too bad if the savers happen to be foreigners like Chinese, Japanese or Middle Eastern sovereign funds that have bought US Treasuries to finance the US trade deficit.

It’s a tempting scenario but not one without considerable risks. An attempt to generate moderate inflation could lead to hyper-inflation if consumers lose confidence in paper. The frightening thing about paper money is that it is mainly backed up by debt and not gold following the demise of the Gold Standard.

Your bank deposits will be paid only if the debt in the banks’ books are honoured. The banking system operates on confidence and trust. As inflation rises, investors would demand a higher real interest on loans and there is a rush to swap paper money with real goods and tangible assets. Interest rates would shoot up and the currency would be devalued, something that happened to the German mark in 1923 leading to hyper-inflation and eventually the rise of Hitler.

Foreign governments would lose confidence in the US dollar and stop buying US Treasuries resulting in higher borrowing costs for the US government and consumers.

The Fed began printing money in the second half of 2008, especially as normal tools like reducing interest rates and the reserve requirements for banks were not working. The economic term used is quantitative easing to confuse the layman. This entails increasing the M1 money base (US dollars in circulation, checkable deposits). When M1 rises, other broader measures of money like M2 (M1 plus household savings) will normally rise. Without the Fed printing money and using the money to inject into companies like Citibank and American International Group (AIG), the US stock market would have fallen more than it currently has.

Ways to print money

There are a few ways the Fed can “print money.” The first and most common way is through open-market operations where the Fed buys bonds from a bond dealer. The cash balance will be electronically created and credited into the dealer’s bank and the bank would lend out the cash.

The second is through repurchase agreements (repos) which are short-term loans extended by the Fed and secured with high-quality collateral. The repos amounts are normally quite large but are mainly used to alleviate short-term liquidity problem of financial institutions.

A third and less conventional way involves the Fed buying troubled assets from banks and the banks can be credited with cash that increases the monetary base.

A fourth way used to recapitalise troubled financial institutions would be to inject cash into financial institutions in exchange for preference shares or shares in the financial institutions.

The Fed is also providing currency swap lines to 14 foreign banks to ensure that these countries have enough US dollars and do not have to resort to selling US assets that will further depress asset prices.

As a result of all these actions, the Fed’s balance sheet has grown from US$883bil on Nov 27, 2007 to US$2.2 trillion on Nov 19, 2008. Not all the increase results in new money being created as some of the liquidity has been removed by the Fed selling bonds which reduces the money base because money is used to pay for the bonds.

Policymakers have indicated that they will do “whatever it takes” and that may mean buying troubled mortgages and corporate bonds to lower interest costs and provide liquidity. The use of the funds will be guided by political motives and, under President Barack Obama, funds will also be used to help the small boys on Main Street like small and medium-scale enterprises (SMEs) and house owners rather than just the big boys on Wall Street. After all, the Japanese even used the money created to buy equities.

Economic contraction despite higher money base

However, despite a higher M1 money base, which has risen from US$1.3 trillion in early 2008 to US$1.6 trillion currently (see chart 1), the economy is shrinking as the velocity of money is shrinking. One way to measure the velocity is to divide the GDP by M1. This measures the ratio of economic activity to money supply. During boom times, money will turn over many times as banks are willing to lend generously and consumers are willing to borrow.

However, during a downturn – when banks are in trouble and consumers are highly geared – banks will be unwilling to lend and consumers unwilling to borrow, resulting in an economic contraction despite a rise in the money base.

The multiplier effect relies on financial institutions to increase loan activity. The GDP to M1 ratio (a measure of velocity of money) fell from 10.33 in the second quarter of last year to 9.79 in the third quarter (see chart 2). A further fall is imminent in fourth quarter as the ratio is falling from a historically high base.

One way to increase the velocity of money is through fiscal stimulus where large infrastructure spending by the government would stimulate growth. This represents direct spending by the government that bypasses the banking system. Fiscal spending is only useful if future returns can be derived; otherwise, it merely burdens future generations with greater debt.

In essence, the Fed’s actions are to ensure proper functioning of the financial system in times of crisis. At present, the increase in the money base is not inflationary as the decrease in the velocity of money more than offsets the rise in the money base.

The Bank of Japan also increased its balance sheet from 2001 to 2006. Its balance sheet peaked at 30% of GDP which means that the Fed with a balance sheet of only 15% of GDP still has room to print more money.

In Japan’s case, printing money did not work as banks simply bought risk-free assets while highly-geared corporations were deleveraging. The US recovery may also be hampered by deleveraging by consumers and new regulation placed to curb excessive leverage in banks.

Property and stocks may be good investments

What are we to do as investors? It would be wise to look for assets (bond, property and stocks) with good yields as interest rates are likely to stay low for a long time. However, if the Fed prints too much money and there is a runaway inflation, then assets like property and stocks would perform better as they adjust to inflation.

Bond prices would decline with higher interest rates. In a way, it was the Fed’s lax monetary policy that led to the debt bubble. Recessions exist to clear away excesses but should the Fed do “whatever it takes” to generate growth, hyper-inflation cannot be ruled out as a possibility, especially if other central banks also rev up their printing presses.

Bank Negara reduced the overnight policy rate by 75 basis points. Such an aggressive cut in rates is sensible as central banks have to be ahead of the curve and cut rates when they still have a positive impact on the economy. In the United States, where rates are close to zero, printing money and fiscal stimulus become the few remaining tools.

With the United States in the throes of deflation, with consumer price index (CPI) in December 2008 contracting by 0.7%, the Obama administration is likely to print a lot more money to buy over toxic assets, recapitalise the financial institutions and inject money directly into non-banking sectors (e.g. motor vehicle industry).

In the new deflationary world heavily laden with debt, inflation (through printing of money) looks like a ray of hope that will deflate debt in a sensible timeframe.

  • Choong Khuat Hock is head of research at Kumpulan Sentiasa Cemerlang Sdn Bhd. Readers’ feedback is welcome. Please email to
    starbiz@thestar.com.my

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