The Effects of Money Supply on the Economy

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Does money supply affect real economic variables such as investment and output (real gross domestic product, GDP) or only the nominal variables such as prices and wages? The monetarists and the Keynesians have been at it since the publication of the General Theory of Employment, Interest, and Money by John Maynard Keynes in 1936.

Milton Friedman, the founder of modern monetarism, famously predicted in the 1970s that both inflation and unemployment would rise if economic planners tried to target ever lower unemployment through discretionary monetary policy by raising money supply, because, in the long run, he argued, the economy would be at potential and prices and wages would rise as a result, but not output, leading to inflation.

The key differentiator of the 1970s experience is that there have been external negative energy supply shocks which led to higher than expected inflation and a recession which led to higher unemployment. Potential growth rate of the economy in the 1970s may have suddenly fallen because of the external negative energy supply shock, otherwise, in the short run without a negative external shock, the economy would have responded as expected to monetary expansion by lowering unemployment further and raising both growth, and inflation if the economy’s output exceeded potential requiring additional labor and capital.

Japan’s experience in both the long run and the very long run over the past two decades presents a puzzle for a monetarist: not only in the short run have real variables such as investment and output not been affected by expansionary monetary policy, but in the long and very long runs money supply has not caused inflation by raising prices and wages. Therefore, Japan’s deflation vindicates the Keynesians because they argue that government intervention through fiscal expansion is needed to lift the economy out of the deflationary mindset to restore growth after which changes to money supply in the short run would affect the economy as expected.

When an economy is left to its own devices in a deep recession or a depression without fiscal expansion to trigger investment, Keynes argued, ever lower interest rates do not provide adequate incentive to market participants to begin to invest because they do not see adequate aggregate demand for their goods and services. At some point, the interest rate targeted by the central bank would be zero (the zero bound as it is known in monetary economics), still unable to change the psychology of the investors.

The period of the financial crisis and the Great Recession of 2007-2009 has been a strong negative shock to the economy. It has once again proved, as had been the case with the Great Depression, that money supply alone cannot recover the economy in a timely manner, including in the short run, in the presence of a shock to investor sentiment, with the recovery taking nearly 7 years to approach near full employment and healthy inflation in the US. Despite an environment of monetary expansion, the reason for the long recovery has been fiscal austerity which was a mistake.

Money supply, except during large negative shocks when government intervention is needed in the form of fiscal expansion, always affects the real variables in the short run as both monetarists and Keynesians agree, and will only affect the nominal variables – prices and wages – in the long run. Most importantly, a monetary rule, contrary to the monetarist view that it always works, however, does not work during shocks to the economy, and discretionary monetary policy from the central bank would be needed as the Great Recession has demonstrated. After all, the monetarist medicine to the US economy dispensed by Paul Volcker from 1979 to 1983 was purely discretionary and had not followed a preset monetary rule, and it behooves to note here that Volcker’s monetarist contraction of money supply had plunged the US economy into a recession altering real economic variables – investment and output – and trading-off, as the Phillips curve says, higher unemployment for lower inflation in the short run.

In the already accommodative monetary policy environment despite very gradual moves to return to normalcy in the US, pro-growth fiscal policies which could bump up the potential growth rates are needed in the Group of Seven (G7) countries to return the global economy to healthy growth and inflation. A stable and gradual transformation of China to a consumption and services-based economy will also certainly help.

The Economics of the Reflation Trade

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Investors in the US financial markets are selling bonds, in particular the long bonds, and buying equities. This trade has been dubbed as the “Trump Thump” because more than $1 trillion of value has been wiped out in two days of reallocation of funds out of the bond market in expectation of higher growth, the return of rising inflation – also known as reflation – after a spell of low or falling inflation or deflation, and higher interest rates from expected fiscal expansionary policies of Donald Trump. The reflation trade toward the end of 2016 is reversing the deflationary expectations of market participants at the beginning of 2016 that were formed due to slowing Chinese growth and slower growth across the advanced economies (AEs) and the Chinese debt bubble. In fact, the Chinese situation led to some forecasters predicting a global recession due to worldwide growth potentially falling to about 2%. Such dire predictions may not materialize.

So, what is causing the reflation?

The Chinese slowdown may not turn out to be a financial or economic crash. It is a controlled slowdown as the Chinese economy shifts from real investment, manufacturing and exports to consumption and services. The high level of debt is also not of great concern given, first, the structural reforms being put in place by Chinese economic planners to gradually wind-down and consolidate the debt-laden and underperforming state owned enterprises (SOEs); second, possible recapitalization by the People’s Bank of China (PBOC) of banks which are carrying non-performing assets (NPA); third, fiscal expansion to direct government monies toward real investments so as to prop up growth; and fourth, the higher level of personal savings in China makes the debt problem not adverse. Further, regulatory measures are being taken by the governments in Beijing and the provinces to gradually cool the property market so as not to cause a bursting of the property bubble at some point when interest rates go up. All these initiatives by China in 2016 are causing a plateauing-off of Chinese economic growth to between 6.5 and 7% abating fears of any dramatic slowdown in either Chinese or global growth which is causing commodity prices and inflation to rise.

In the United States, the determinants of the next crisis or a recession are, at the moment, non-existent. Growth is strong and so are expectations of growth and inflation, propelling the financial markets to boost equities and raise yields on the long bonds. Expectations of fiscal expansion through higher infrastructure spending, lower corporate taxes, and initiatives by the incoming Trump administration to repatriate corporate profits from offshore give US monetary policy the necessary elbow room to continue to raise interest rates gradually without the fear of adversely affecting growth. Fiscal policy can possibly trigger productive public-private partnerships to raise real investment in areas which would have otherwise not been possible through monetary policy alone. With the Chinese fiscal expansion and expectations of the same from the US, the world is moving away from fiscal austerity policies that have plagued economic growth since the Great Recession to finally promote growth. Also, growth and oil production cuts will eliminate surplus oil supply and can bring the oil market – and commodity markets at large – into balance, alleviating the troubles of the global energy and mining industries due to low oil and commodity prices.

Reflation, however, could affect the emerging markets (EMs) by raising their inflation levels, challenging their inflation targets. Moreover, the strength of the US dollar will make their imports expensive further making managing inflation a challenge, while their depreciating currencies will make their exports cheaper even as it is necessary for the EMs to reduce their export dependence while remaining export competitive. Most importantly, the downward pressure on the Chinese renminbi (yuan) could cause China to continue to depreciate it so as not to defend an artificially stronger yuan which would be a drain on China’s foreign exchange reserves. The extent of the downward pressure on the yuan will determine how soon China will fully float the yuan without the need to defend the currency, using its foreign reserves, at any level to justify the yuan joining the International Monetary Fund’s (IMF) basket of global reserve currencies.

The reflation trade could be the beginning of the end of the global slowdown and secular stagnation after the Great Recession.

The Globalization of Neoliberalism and its Backlash

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The term “neoliberalism”, though it originated to mean a “third way” between a laissez-faire capitalist economy – or classical liberalism – and socialist planning, has – since its resurgence in the 1970s in connection with the economic reforms of Augusto Pinochet in Chile under the advisement of Henry Kissinger and Milton Friedman – come to mean pro-market reforms with less state intervention in the economy. It has thus meant not only deregulation in the United States of Ronald Reagan and the United Kingdom of Margaret Thatcher but also, for example, the gradual opening of China to international trade and foreign investment and the 1991 economic reforms in India.

While in China and India neoliberalism means achieving a social market economy under the guidance and rules of a strong state, in the US and the UK it means closer to laissez-faire capitalism. In fact, the purpose of the Reagan and Thatcher reforms was to respectively take the US back to pre-1930s capitalism and the UK economy to a pre-Fabian Socialist condition.

Debt carried by individuals and corporations was not a large factor in the economy before the 1930s. Two financial innovations since the 1930s – the 15 and 30-year mortgages and the credit card – have spurred consumption and led to economic growth in the United States after the Great Depression. Since then these innovations have spread around the world. The democratization of the availability of credit based on personal income or on the ownership of an asset such as a car, other durable goods, or a home, though a constructive development, has, by the beginning of the new century, turned into a burden for the economies of the world: consumers’ debt-to-income ratios have ballooned whether that debt be for buying durable goods, buying a home, day-to-day consumption or getting an education.

The financial world was brought down to its knees by debt when the housing market collapsed in the United States. Being in the middle class has become carrying a debt burden that is serviced by a month-to-month paycheck, with consumption draining the possibility of any savings but paradoxically helping the economy grow. Since the 1980s, the United States has become a net debtor to the rest of the world and the debt load of American consumers has increased considerably. Even as savings rates are significantly higher than America in the rest of the world, the globalization of neoliberalism has begun to make people in the rest of the world also consume by taking on more debt raising the risk of default and ensuing financial crises.

The rise of the modern global corporation since the turn of the 20th century technological change created secure livelihoods for people that lasted a life time and built a robust middle class even as it created business tycoons. The introduction of social security, medicaid, medicare and other programs of social safety in the US protected the poor and the retirees.

The turn of the 21st century technical change, however, combined with neoliberalism, in particular since the 2007-2009 recession, has frayed this 20th century economic fabric creating a precariat class that is becoming largely self or intermittently employed or even underemployed in the “gig economy” for extended periods of time, lacking in both job security and retirement security. The middle class is being considerably weakened, increasing the gap between the very rich – who constitute the plutonomy – and the rest, and this time such income disparity could become a permanent feature of all neoliberal economies primarily because of labor-displacing technological change. In fact, despite the goal of becoming a social market economy, for example, India lacks a social safety net and is the second most unequal country in the world (the former communist Russia is the first) as it continues to press ahead with neoliberal economic reforms.

Neoliberalism has caused rising economic inequality within countries even as it reduced the inequality between countries because of economic globalization. This is the paradox of a nation’s gross domestic product (GDP) and its “forgotten people.” The legitimately populist backlash to neoliberalism is, therefore, due to rising income disparities in countries.

More than the aging and retiring populations in the West, Japan and China, rising income inequality could be reducing economic growth in these parts of the world and not promoting growth in other parts of the world such as India, despite their younger populations, because formation of a strong middle class is prevented by neoliberal policies which are responsible for the precarious existence of the rising ranks of the jobless young especially in an environment of disruptive technological change which is being rapidly globalized.

Neoliberalism is fundamentally unsustainable because of the natural resource economics of ever higher consumption and because of the socio-economic conditions it creates. The world is on the cusp of a new paradigm of economic development.

Why Both Growth and Inflation Target May be Tricky to Achieve for India

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The inflation target of India, instituted by the Reserve Bank of India (RBI) and the Indian government, is 4% consumer price index (CPI) change within a band of 2 – 6%. For the last quarter of the fiscal year 2016-2017 – the quarter from January 2017 – March 2017, the RBI is expecting to contain inflation to 5% and in the medium term maintain inflation in the range of 2-6%.

India’s economy has been growing strongly and lower commodity prices have helped India achieve growth since 2014 while keeping inflation contained because of slow global economic growth. But this may be changing now. The expectation of pro-growth economic policies by the US president-elect Donald Trump has, on one hand, buoyed the financial markets in the United States shifting investors interest from the safe haven of bonds to stocks raising bond yields, and on the other hand, because American unemployment is low and near to full employment, has raised the prospect of faster rise in inflation ending the prolonged period of low inflation. This could become a contagion globally, igniting growth around the world. The world economy is showing signs of reflating. Industrial activity across the United States, Europe and China appears to be on an upward trend, and is pushing up commodity prices.

This change in global economic conditions has not gone unnoticed by the RBI. In its Fifth Bi-monthly Monetary Policy Statement, 2016-17 Resolution of the Monetary Policy Committee (MPC), the RBI has stated that:

“Global growth picked up modestly in the second half of 2016, after weakening in the first half. Activity in advanced economies (AEs) improved hesitantly, led by a rebound in the US. In the emerging market economies (EMEs), growth has moderated, but policy stimulus in China and some easing of stress in the larger commodity exporters shored up momentum. World trade is beginning to emerge out of a trough that bottomed out in July-August and shows signs of stabilising. Inflation has ticked up in some AEs, though well below target, and is easing in several EMEs. Expectations of reflationary fiscal policies in the US, Japan and China, and the waning of downward pressures on EMEs in recession are tempered by still-prevalent political risks in the euro area and the UK, emerging geo-political risks and the spectre of financial market volatility.

International financial markets were strongly impacted by the result of the US presidential election and incoming data that raised the probability of the Federal Reserve tightening monetary policy. As bouts of volatility fuelled a risk-off surge into US equities and out of fixed income markets, a risk-on stampede pulled out capital flows from EMEs, plunging their currencies and equity markets to recent lows even as bond yields hardened in tandem with US yields. The surge of the US dollar from late October intensified after the election results and triggered sizable depreciations in currencies around the world. Commodity prices firmed up across the board from mid-November on an improvement in the outlook for demand following the US election results, barring gold which lost its safe haven glitter to the ascendant US dollar. Crude prices have firmed after the OPEC’s decision to cut output.”

The RBI summed up its statement with an assessment of inflation thus:

“Turning to inflation, food prices other than vegetables are exhibiting sustained firmness and a pick-up in momentum. Another disconcerting feature of recent developments is the downward inflexibility in inflation excluding food and fuel which could set a resistance level for future downward movements in the headline. Moreover, volatility in crude prices and the surge in financial market turbulence could put the inflation target for Q4 of 2016-17 at some risk.”

Though good for Indian exports, the depreciation of the rupee against the US dollar could, in fact, put upward pressure on inflation in India because imports become expensive. This, when combined with strong economic growth, can raise inflation closer to the RBI’s upper limit of 6% as the Indian central bank recognizes.

Though monetary policy transmission when lending rates are lowered is being hampered by factors such as non-performing assets (NPAs) of commercial banks and the small size of India’s financial markets, when lending rates tick up the transmission is faster. To keep inflation within target, therefore, India may have to settle for slower growth by raising interest rates at some point.

The Goldilocks period of sustained strong growth in an environment of low global inflation may be coming to an end for India.

What Demonetization Can Buy for India

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The independent think tank and leading business information company Center for Monitoring Indian Economy (CMIE) estimates that the combined cost of demonetization to enterprise, households, banks, and government (including the Reserve Bank of India) is about INR 1.3 trillion or about USD 20 billion.

Economists often use the concept of opportunity cost to understand what has to be given up in order to get what one wants: India has given up USD 20 billion, which could have been put to other uses, to get in return an economy with an expectedly far less unaccounted for cash, or in other words, India is expecting to “purchase” with USD 20 billion a far less corrupt economy.

Some estimates of India’s gross domestic product (GDP) for the period October-December 2016 say that nearly 1% could be shaved-off GDP growth. Are India’s prime minister Narendra Modi’s efforts to significantly reduce corruption by first clamping down on the cash unaccounted for by the tax authorities, or “black money” as they call it in India, worth the cost to the economy due to the demonetization drive and the consequent short term hit to GDP and the financial markets especially when interest rates are expected to rise in the United States after the election of Trump triggering capital flight from India and depreciation of the rupee just as it did previously during the taper tantrum when the U.S. Fed gradually ended its policy of quantitative easing?

The shock of about 86% of cash being taken out of circulation to remove, as economics Nobel Laureate Amartya Sen has pointed out, only 6% of black money that is actually in cash could, on the surface, seem excessive, but to disagree with Sen, there is no other alternative to demonetization to end the hoarding of ill-gotten gains. The government, in contrast to Sen’s labeling of it as being despotic in its actions, has, in fact, twice allowed the holders of hoarded cash to come forward voluntarily to convert it into white money by depositing in banks and paying the taxes with the penalties due on it. The INR 500 and 1000 notes continue to be legal tender as long as they are deposited in banks or exchanged for the newly designed INR 500 and 2000 notes within a prescribed timeframe: the government is indeed honoring its currency as legal tender. It is not despotic to ask cash holders to exchange old design notes for new design notes within a timeline.

At issue really is whether demonetization can actually end black money and other ill-gotten assets in the future. This is why it appears that it is a mistake to introduce two new currency notes of large denominations – the INR 500 and 2000 notes. Despite the government’s sound intent to convert what is a cash-based society into a digital society, the introduction of these notes poses the danger of recidivism. Moreover, once the circulation of cash attains normalcy again, the momentum gained toward a digital economy during the period of demonetization could be lost as people may tend to revert back to transacting in cash. It would, therefore, be good to see INR 500 and 2000 denomination notes demonetized with INR 100 becoming the largest denomination. Further, given that only a small percentage of black money is in cash and the rest of it lies in foreign currencies typically in Swiss bank accounts or offshore, gold, financial assets such as stocks, and real estate, it is unclear at this time how the government can account for all of it though the government needs to chart a clear course for it to forever end the shadow economy.

India is a highly desirable market to the extent that foreigners are willing to transfer technology to India to get a share of the Indian market. It is large enough not to depend on the comings and goings of foreign investment to be continually concerned about the depreciation of the rupee because of temporary domestic events such as demonetization or foreign happenings such as the election of Donald Trump in the United States. “Make in India” for the Indian market is a worthy goal to pursue for both foreign investors and Indian investors to reduce the reliance of the Indian economy on exports (and hence a cheaper rupee) as much as export competitiveness is necessary. More importantly, India can reduce imports, except of natural resources such as oil and gas and other minerals India does not possess, if it makes in India, boosting the Indian manufacturing sector. There is no reason at this time for the Indian rupee to depreciate against the dollar but for fleeting market sentiment about the prospect of higher US interest rates. India continues to be an attractive country for foreign direct investment (FDI) and foreign institutional investment (FII).

Strengthening the domestic market thus makes the rupee optimally strong at all times, similar to the US dollar, charting a path for the full convertibility of the rupee in the near future and its use as one of the reserve currencies in international trade. And all of this does not require dependence on cash because investment in India by both domestic and foreign investors can happen digitally and the economy can be steadily pushed to attaining the goal of all digital transactions by giving incentives to market participants and instituting laws to digitize especially when the technology to do so for all transactions, small and large, is readily available.

Digitization of the currency is the way to go and if the opportunity cost to achieving it is a small, short term, and temporary hit to Indian GDP and the Indian rupee, so be it.