The Global Economy Is Facing a Hotel California Problem

As of November 3, the total assets of the US central bank stood at $8.57 trillion, the highest ever. Almost all of the expansion of the Fed’s balance sheet has occurred after August 2008. As of early September 2008, its balance sheet size was $905 billion. From there, it continued to grow to reach a peak of $4.52 trillion in mid-January 2015. Why did this happen? In mid-September 2008, a major investment bank, Lehman Brothers, collapsed. This brought the global financial system to the brink of collapse and raised fears of another Great Depression.

Over the years, American economists have come around the idea that a major cause of the Great Depression that began in 1929 was the lack of money around the American financial system due to the collapse of many banks.

So, eight decades later, the Fed bought Treasury bonds and mortgage-backed securities (MBS) and flooded the financial system with money. Treasury bonds are bonds issued by the US government to meet its fiscal deficit. Also, when banks and financial institutions secure their mortgage or home loan, the financial securities that come out of it are called MBS. The Fed printed money to buy these bonds. In the true sense of the word, there is no printing of real money, as the money is created digitally. But the process of making money out of thin air is equivalent to printing it.

Thanks to its bond-buying, the Fed’s assets were nearly five times the September 2008 figure in January 2015. The idea was that by putting so much money into the American financial system, interest rates would drop and people would borrow and spend, companies would borrow and expand. With this, economic activities will resume.

After January 2015, the Fed began to shrink its balance sheet by selling off the bonds it bought and slowly trying to suck up the money printed. This continued through 2019, and by the end of September 2019, the size of its balance sheet had shrunk to $3.76 trillion.

In early 2020, the COVID pandemic hit and economic activity came to a standstill. The Fed went back to its 2008 toolkit, increased printing its money and began buying bonds again. In the process, the Fed’s balance sheet more than doubled in size. In absolute terms it has had a greater post-Covid extension of its existence than it did more than a century ago. It was not just the US central bank that resorted to the printing of money on a large scale; So did other central banks around the world.

On November 3, the Federal Reserve announced that it would slow its purchases of Treasury bonds by $10 billion per month and MBS’s by $5 billion per month. If this pace of reduction in buying continues, it is expected that the Fed will stop printing money and bond-buying by June 2022. This is expected to have a huge impact on the global economy.

As economist Ronald Coase puts it, “All solutions have a cost.” To which Diane Coyle adds in Cog & Monsters: What Economics Is, What It Should Be: “A specific policy or regulation may solve one problem but cause others elsewhere… For example attributed to economists’ habit of viewing their jobs as fixing a problem in a particular context, which will result in a change in behaviour.”

While money printing was supposed to stimulate economic activity by encouraging companies and individuals to borrow more, it also led investors to seek higher returns and drive up stock prices. Real estate prices have also jumped in large parts of the Western world. Investors have also pushed up commodity prices, from oil to coal, in search of higher returns. And the prices of cryptocurrencies and valuations of unicorns have reached mind-boggling levels. In their pursuit of economic growth, central banks and governments have created massive financial bubbles.

Tapping will slow down the printing of money, the fuel that feeds the bubble. If the Fed and other central banks are able to keep up with this and reach a stage where they can begin to shrink their balance sheets by selling off the bonds they buy, the speculative financial economy that has emerged over the past few years may well be a Will kill The prices of stocks, commodities, real estate and cryptocurrencies will fall. So will the unicorn valuation.

On the other hand, for a country like India, which is heavily dependent on imports of commodities like oil and coal, a fall in commodity prices would mean good news on some fronts. It may also mean that the growing inequalities in our society will get a brief break.

The question is whether the Fed and other central banks will be able to move forward with this, or will they be chickened out if stock prices fall on an ongoing basis. To conclude, as The Eagles first sang in Hotel California (1977): You can check-out whenever you want, but you can never leave. Today’s global economy, which has become dependent on the printing of money by central banks, has become something like this. It’s easy to drop the can down the road.

Vivek Kaul is the author of ‘Bad Money’.