Sunday, 8 March 2009

All Those Zeros

8th March 2009
The Malta Independent on Sunday

It is hard for many people to really appreciate the huge quantitative difference between a million and a billion. For most these are just big numbers starting with a different letter. Reality of course is much different. The three zeros tacked on to the million’s six zeros make a hell of a difference.

To put it in perspective that can be better appreciated, a billion seconds take nearly 32 years to tick away. So when a person is billionaire one would really have more riches than could be spent in several lifetimes. When you hear that governments are spending hundreds of billions, and in the case of the US more than two thousand billion (voted so far) to stabilise their financial structures and to stimulate their slowing economies, then we are talking about serious money.

So it is obvious that people would ask where all this money is coming from. The short answer is governments borrow it, tax it or, as a last resort, print it. That in simple non-technical language is what governments are or will be doing in order to finance the various initiatives they are being constrained to launch to protect their financial systems from collapsing and their economies from falling into a depression.

In normal circumstances, governments finance their expenditure from taxation. From time to time they have to borrow, particularly to finance non-recurrent infrastructural and social investments that are designed to augment the productive capacity of the economy for the longer term. However, such borrowing is generally contained within a few percentage points of the country’s GDP. Developed economies try to keep such annual borrowings to within three per cent of the GDP and to balance out the Budget over an economic cycle, i.e. when the economy is performing at its optimum and the government has high tax revenues and low social unemployment payments, the budget has to balance or go into surplus to leave space for deficit spending when the economy turns down. Developing economies with a lot of infrastructural investment yet to be financed tolerate larger annual deficit until they reach maturity stage. But in all cases accumulated debt is generally kept to within 60 per cent of the GDP and if this level is exceeded in the development stage it will be brought down at the maturity stage.

These however are not normal circumstances. Far from it! Governments cannot raise money from taxation given that present soft cyclical stage reduces the tax take and increases the social spend on unemployment benefits.

Raising taxation now would continue to flatten the economy rather than re-invigorate it. So governments have to resort to borrowing.

Reducing interest rates makes the burden of additional borrowings more manageable but the quantity of money that needs to be borrowed is so huge that it goes beyond the capacity of the individual countries to find the necessary savings to finance such borrowings. Especially in countries like the US and the UK with a traditionally low savings culture, domestic markets have limited capacity to finance governments’ exploding borrowing requirements. Resorting to foreign borrowings is inevitable but given the low rates on offer even this may not be found in the quantity required.

Which leaves basically one source to finance government’s borrowing requirements. If all else fails the government may need what politely are being referred to as “non-conventional measures”, and what has technically been coined with the confusing term of “quantitative easing”.

In normal everyday language this is nothing other than mere creation of money by printing it, or in these electronic days by merely having the central bank buying government and private sector bonds and paying for these by newly created money, which are merely IOUs on the central bank.

This is a truly extreme measure that central banks only resort to in extreme circumstances. Outside Japan, this is the first time such measures are being resorted to in the post-war era.

Does this mean that the USA, UK and Japan, which are being forced to resort to such extreme measures, will become just like Zimbabwe where money has lost its value due to hyperinflation measured in millions of percent per annum? Is not this free printing of money what caused two hyperinflation experiences in Germany in the first half of the 20th century?

No, it does not mean that, at least not unless the central banks sleep at the wheel when the economy recovers eventually. Japan had used quantitative easing in the nineties, yet it is still in depression mode. Of all the problems with the Japanese economy, inflation is not one of them. By adopting quantitative easing, the central banks of USA, UK and Japan (and who knows, quite soon they may be joined by others in a global co-ordinated response involving also the ECB) are in fact trying to create some inflation to avoid the world economy from falling into a depression where prices are entrapped into a spiral caused by falling demand leading to unemployment, further price falls, and further destruction of demand.

Central banks in developed countries are having to create and literally print money in order to stimulate demand to fill a slack in the economy where supply is not finding sufficient demand leading to inventory build-up and unemployment. Money has simply stopped circulating as people save more due to fear of an uncertain future. Therefore, a much larger quantity of money is needed by the economy to maintain the demand level as close as possible to the supply capacity. This is quite different from Zimbabwe style inflation where money is printed to meet excessive demand just when supplies run short due to an economy that stops producing goods due to malfunction, or due to allocation of productive capacity to non-consumer goods (for example, Germany’s spending to build up the war machine).

Where does the risk of inflation lie? It is certainly not an immediate risk, as in fact central banks are trying to create not control inflation. It would become a problem if central banks actually succeed in their efforts to stabilise the economy by creating some inflation and re-stimulate demand. If at that point money starts circulating at a faster pace, central banks have to be very agile and quick in reversing the “quantitative easing”, i.e. selling back the bonds they are now buying and demonetise the money they are now creating. Unless they eventually do this in an effective and timely manner, inflation would then, two or three years down the road, really become an issue.

One thing is sure however. Having come to the point where central banks have to adopt non-conventional measures to try to create inflation is of itself indicative of the gravity of the economic morass in which the world is engulfed. It’s tough being a central banker these days. It’s tough for the consumer to find the necessary confidence to defeat “the paradox of thrift” explained by Keynes. While saving is needed for the long term, for the short term the world needs consumers to save less and increase consumption to avoid falling into a depression.

All those zeros are confusing enough. But if we allow the world to fall into a depression it will be simply painful. Better a confusing solution than a simple defeat!

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