QE and Economic Growth

Last week Monday (i.e. September 19, 2011) the Bank of England claimed that "Quantitative Easing (QE) alleviated economic crisis" It is stated that " .... its first to measure the effect of QE on the economy, found it provided a "significant" aid to growth and helped GDP increase by between 1.5% and 2%. This was equivalent to dropping interest rates by between 1.5 and 3 percentage points .... "

This article remembered me another article which was published in Buttonwood of Economist on Jan 4, 2011 titled "Show me (the Effect of) the Money". This article states that "David Ranson of Wainwright Economics is a sceptic on this issue and has analysed the data over the period of 1950-2007. He has looked at monetary base growth rather than M2 or broader measures for one very good reason. It is clear that QE has had a much greater impact on the monetary base (doubling it in the autumn of 2008) than on other measures such as credit growth" (Note: The analysis is done on US Data)

It is further stated that "Ranson divided the 57 years period from 1950-2007 into two-years  when the monetary base grew at an above average rate (8.1%) and years below average growth (3.5%). Economics growth was higher (3.7%) in the years of slow money growth than it was in the years of rapid growth (3.2%). The same is true for industrial production. Even the stock market performed better in years of sluggish money growth". The Economist went on to claim that QE will not really help the economy. Now, Bank of England claims that QE helped their economy to move further. 

For some point of time QE was not in newspapers or aticles; but now they are back, thanks to the EURO debt crisis and Bank of England. Three days ago (i.e. 27.09.2011) in Economist again there was an article titled "Which region needs QE?", the article made comparisons on three economy's namely U.S. , England and euro area over the QE. It went on to say that euro area have slowest of the money growth.


After reading these three articles few questions raised in my mind 1. Do QE will really help the economy to move faster away from any crisis? 2. Why QE fails in U.S. when it can help the other economies? (I think probably due to poor banking managment) 3. Is there any direct relationship between QE, Inflation and Growth Rate? It's not easy to answer all these questions, but history and repeated economic events/crisis gives some near answers for these questions. (Leaving open ended for analysis)

RBI's Goodwill At Stake?

From the recent review, actions and projections of RBI, I am really baffled on What RBI is trying to do? and raised the question that whether RBI had Gone Mad? I may not be an expert on these lines, but, being an economics student one can at least feel the pulse to certain extent. 

In an weekend newspaper M.D.Nalapat had written an article titled "The RBI had Gone Mad". In this article, the writer says that "India Inc has been crippled by the duo's policy of relentless rate hikes, ostensibly to "rein in inflation". Neither Reddy nor Subbarao had IQ needed to understand that Inflation in India is caused by factors other than the Interest Rate is a Tragedy for the Country". 

He further stated that "Inflation since the UPA took office in 2004 has been largely caused by uncontrolled Government spending, mostly on programmes that are designed to increase the tally of the congress for the next elections. Thus, instead of public works programme that would expand rural infrastructure, what has been implemented is a dole that does nothing to ensure that permanent employment opportunities form as a result of the huge Financial Outlays of the Sonia Gandhi-approved schemes" 

Of course, this post is not about the writer's political view or his general view.  But the above mentioned article have few valid points, which we need to note, that Inflation in India is not only because of the money supply but it is due to various factors. (Austrian economist may argue differently - but, we are not here for any debate). This article further strengthen my queries and doubts on RBI, here are the 2 major points from this article which supports my query on credibility of RBI


1. The article says that Inflation in India is not due to the prevailing interest rates but it is due increase in uncontrolled Government spending. (RBI failed to feel the pulse?)


2. The Interest rate in India is much higher compared to any developed nation(not even UK and Europe) and China is the only country which comes closer to our interest rate.


This article is not the only reason which made me to raise question on RBI's credibility. There are more valid reasons, they are as follows: 


Few days before (i.e. on 16 September, 2011) RBI had announced its quarterly review with an hike of 25 basis points (as expected). They came with the usual reply that this move is to control prevailing inflation. Despite the fact (I hope they know) that raise in interest rate alone cannot contain the present inflation rate. 


For the past few years, predictions and revisions of the Central Bank (RBI) have gone hand in hand. In recent past, whenever RBI makes prediction it hardly takes a month or so that it revises its own estimates. After 3 times revision, RBI had predicted the Inflation level of 8% for the year 2010-11, whereas, the actual Wholesale Price Index (WPI) by March 2011 ended at 9.68 %. In the latest review it predicts that inflation will be 7% by the year-end (i.e. March, 2012). (Note: The current (August) WPI stood at 9.78% (Provisional) as compared to 8.87% corresponding month of last year (2010)) 


Being the Central Bank of country, if RBI fails to feel the pulse of the economy, then it will be a great difficulty for the nation to achieve its macroeconomic objectives. Already people have started losing their confidence on RBI. RBI's credibility and laud which it had received from across the globe are now at stake. In simple, RBI's Goodwill is at stake. 

Some Basic Economics Lessons - Fiscal Deficit

      The Standard & Poors (S&P’s) had recently downgraded U.S. in their credit rating from AAA to AA+. After a week of the downgrade, Deven Sharma, then the president of S&P’s, got fired from the post (even though many newspapers quoted that he had step down) .
         

    The S&P’s report stated that “We have lowered our long-term sovereign credit rating on the United States of America to 'AA+' from 'AAA' and affirmed the 'A-1+' short-term rating.” It also stated further that “ The downgrade reflects our opinion that the fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government's medium-term debt dynamics.”
                

     Many people criticised the downgrade of the U.S. credit rating and few people supported the downgrade of U.S. credit rating with statement that it is due to growing fiscal deficit in U.S.. Of course, it will be a very interesting topic do an analysis on the latter part and one can write a good article on it. But, that's not going to be done here now.

      Now let's go to the basic lesson and see what does fiscal deficit means, its components and what does it indicate to us?

    Fiscal deficit is an economic phenomenon, when Governments total expenditure exceeds its revenue. In simple terms, it is the difference between government's total receipts (excluding borrowing) and total expenditure. There are two primary component of Fiscal Deficit; they are Revenue Deficit & Capital Expenditure.

    Revenue deficit is defined as the actual net amount received (i.e. revenue minus expenditure) fails to meet the projected (or predicted) net amount to be received. In other words, when the actual amount of revenue received and/or the actual amount of expenditures do not tally with the projected revenue and expenditure figures. Capital Expenditure is famously known as CAPEX. It is the expenditure incurred for creating future benefits. In simple terms, the expenditure incurred to create physical assets like buildings, machineries, equipment’s, property etc.... A capital expenditure is incurred when the money is spent on either to buy fixed assets or to add to the value of an existing fixed asset.

    Fiscal deficit is an indicator to the government, about the total borrowing requirements from all sources.

Fiscal Deficit in India:

       In India, the fiscal deficit is financed by obtaining funds (money) from Reserve Bank of India (this is also called as deficit financing). The fiscal deficit is also financed by obtaining funds from the money market (primarily from banks). As per RBI Annual Report, the Fiscal Deficit for the year 2010-11 (Revised Estimates) is 7.7% (combined – Centre (5.1) and State (2.6)); whereas the Budget Estimates for 2011-12 is expected to be 6.8% (Centre - 4.6% & State - 2.2%)  

    

    

U.S. Debt Ceiling

On 27^th July, 2011, an article titled "Q. and A. on the Debt Ceiling" was published in New York Times. The same article was published in "The Hindu" on 29^th July 2011 titled "A Crash Course in all the things Debt Ceiling - Michael Cooper, Louis Story" 

Today (i.e. 1^st August, 2011), U.S. President Barack Obama had announced their deal on debt limit. Even though it is announced, the deal still has to be passed by both the Senate and the House of Representatives. However, it is expected that, the deal will get approved before the deadline (i.e. midnight of Tuesday), beyond which the U.S. Treasury had warned that the federal government would not be able to pay its bills.

The new deal was tied to cut the $14.3 trillion national debt amid of higher public spending. The deal will be implemented in 2 stages. In the First stage of plan, Special Congressional Committee has to find $ 1.5 trillion in savings by the end of December. The Second stage of plan is to cut the public spending by $ 1 trillion over the next decade (i.e. next 10 years). The deal is expected to have certain relief for U.S. economy.

My reflection

Perhaps, this is the best possible debt ceiling deal which U.S. would have struck. There are few question arises over the deal; they are 1) why there is emphasis only on cutting public expenditure and there is no signal or even utterance on taxes? (This is pointed out by some of the senate and house of representative members) 2) why did U.S. took so long to strike this deal (when it is to be without mention of tax), despite the debt crisis had started way back and got further deeper in May, 2011?

Will Euro Survive?

Last year, when I started to write this blog, (in May, 2010 - more than a Year Now!) in a post titled "Austerity Measures - everywhere around Europe" I had mentioned that I would not be surprised if EURO fails or dissolved. The current crises in Europe are showing some sign of Euro breakdown, even though it may not happen much sooner. Analyst and economist may feel this is a skeptic view, but, truth is always hard to accept.

Before going further, let me give a brief introduction on Euro "Euro is the official currency of the Eurozone which consist of 17 countries out of the 27 member states in the European Union. The euro was launched on 1 January 1999, when it became the currency of more than 300 million people in Europe. For the first three years it was an invisible currency, only used for accounting purposes, e.g. in electronic payments.  Euro cash was not introduced until 1 January 2002, when it replaced, at fixed conversion rates, the banknotes and coins of the national currencies like the Belgian franc and the Deutsche Mark" (Source: ECB website)

Coming back to the topic, that many economists and analyst now feels that Euro may fail and soon it may get dissolved. But, Professor Milton Friedman, Nobel laureate and Famous Monetarist, had this view even before Euro came into operation. In his interview to ABC Australia on 17 July 1998 that 

"In establishing the common currency area, the Euro, the separate countries are essentially throwing away this adjustment mechanism. What will substitute for it?

Perhaps they will be lucky. It may be that events, as they turn out in the next 10 or 20 years, will be common to all the countries; there will be no shocks, no economic developments that affect the different parts of the Euro area asymmetrically. In that case, they'll get along fine and perhaps the separate countries will gradually loosen up their arrangements, get rid of some of their restrictions and open up so that they're more adaptable, more flexible."

Friedman kept his view unchanged even in 2005, less than one year before he died (at age of 94 years)

"The euro is going to be a big source of problems, not a source of help. The euro has no precedent. To the best of my knowledge, there has never been a monetary union, putting out a fiat currency, composed of independent states. There have been unions based on gold or silver, but not on fiat money—money tempted to inflate—put out by politically independent entities. - Interview with New Perspectives Quarterly Magazine, 2005"

Some economist felt that Friedman was pessimistic in his view, and few said that Euro will not break-up or dissolve. They support their argument with the following stance that "Countries in the European member states are incredibly linked far beyond just sharing a common currency. The Borders of the countries have essentially been erased, the trade and even citizens can move freely between the Eurozone countries." It is true that Prof. Milton Friedman’s prediction is yet to come true, but it may happen sooner or later.

The current crises are showing the sign of break-up in Euro currency in the near future. The Greece crisis, which is slowly spreading to the rest of European member countries, will eventually make the member economies to move to their own currency after certain period of time. Still it’s too early to say how things will take its own shape.

Greece Austerity Measures - An Analysis

For the past one month, there is severe protest happening in Greece against the Austerity Measures. European Central Bank (ECB) and IMF had asked Greece to take essential Austerity Measures before they claim the bail-out package. ECB watched Greece very closely on their decision on austerity measures.

Let us have a look on the Austerity measures. The Austerity measures are mainly classified into 2 parts, one is Tax Increase and other is slash in Public Spending. They are as follows:
Tax increases include

• A solidarity levy: At 1% for those earning between €12,000 (£10,800) and €20,000 a year, 2% for incomes between €20,000 and €50,000, 3% for those on €50,000 to €100,000, and 4% for those earning €100,000 or more. Lawmakers and public office holders will pay a 5% rate.

• A lower tax-free threshold: People will now pay tax on income over €8,000 a year, down from €12,000. This basic rate of tax will be set at 10%, with exemptions for those under 30, over 65, and the disabled.

• Sales tax: The VAT rate for restaurants and bars is being hiked from 13% to the new top rate of 23%. This rate already covers many products in the shops, including clothing, alcohol, electronics goods and some professional services.

Spending cuts include:

• Public sector wages: Salaries will be reduced by 15%.

• The public sector wage bill: The goal is to cut 150,000 public sector jobs, through a hiring freeze and abolition of all temporary contracts. This should cut the total bill by €2bn by 2015.

• Social benefits and pensions: The retirement age is being raised to 65. Increased means testing, and cuts to some benefits, will reduce the total amount spend on benefits by €1.09bn in 2011, then €1.28bn in 2012, €1.03bn in 2013, €1.01bn in 2014 and €700m in 2015.

 (Source: Guardian.co.uk)

 The current Greece crisis raised few questions like, whether the Greece will take the Austerity measures despite of huge protest in the country? whether it will default or will continue with Euro?

Many economists and experts expressed that Greece have only one solution and that is to leave EURO and Default. But, leaving EURO is not easy and unfortunately, not an option for Greece at this point of time. In 1998, the founding members of the euro-area agreed to lock their exchange rates at the then-prevailing levels. Leaving the Euro means breaking its commitment and the very  motivation for leaving would be to change the parity. Leaving Euro will not only allow Greece to deal with sovereign debt crisis, but also it will be in middle of a bank run, while everyone would be trying to avoid ending up with devalued drachma (Greece currency before joining EURO).

If Greece leaves, then the other countries like Ireland, Portugal and may be even Spain might also follow on the same line (because they are also looking for the bail-out package since their economy is also in tussle to pay off their debts). This will lead to banking crisis in all these countries, by holding their debts which might lead to banking crisis in UK and German (because they are the major creditors for these countries), which will put entire Europe in crisis. These are the some major constraints and problems why Greece cannot leave EURO.

But, the economist who expressed their views that Greece should leave EURO have their own reasons. If the Greece does not leave EURO at the this time, when the economy is already very weak, then there is a risk that the economy will spiral down further in the crisis. It's hard decision which Greece had made for Austerity measures, since they did not have any other better option.

I remember a famous line of Ludwig Von Mises in his book Human Action, which is as follows:

"There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved."

How True it is, a voluntary abandonment or later as a Final and Total Catastrophe of Currency System, even though he said this for credit expansion, this line is perfectly suitable for Greece.

What do you do while waiting for the revolution? - An Interview by Abhijit V Banerjee and Esther Duflo

"There is an easy confusion between "big questions" and "big answers". It is not that because the problem of poverty is large that the solution also must be large. "

How true it is!! It is not at all essential that big problems will have big or large solutions. Many times (even in Life) big problems have small solutions. The above mentioned line in quotes was from an Interview by Abhijit V. Banerjee and Esther Duflo authors of the Book titled "Poor Economics: rethinking poverty and the ways to end it". Their Interview had recently appeared in Times of India Crest (Special Saturday Edition) this week (i.e. 11.06.2011): the registered user (free registration as of now) can see full interview here and others can read the gist of the interview below:

Abhijit V Banerjee and Esther Duflo are among the most respected, watched, and discussed economists in the world today. Banerjee is currently the Ford Foundation Professor of Economics at MIT. Duflo, is Abdul Latif Jameel Professor of Poverty Alleviation and Development Economics at MIT. In 2003, the duo co-founded the Abdul Latif Jameel Poverty Action Lab at MIT, which is best known for its pioneering efforts in conducting randomised control trials to test the real-world effectiveness of interventions believed to alleviate poverty. Their new book ‘Poor Economics: rethinking poverty and the ways to end it’ powerfully argues for a focus on the “smaller” questions in development. They make a case for more evidence-based policy-making , and warn that a great deal of development policy today hinges on “the three Is: ideology, ignorance, inertia.” The authors discussed their new book with Rukmini Shrinivasan in an email interview.

The success stories you talk of are of modest successes - how school attendance can go up, how to promote mosquito net usage etc - but we aren't seeing mass educational or health transformation. The NYU economist Bill Easterly calls this a lowering of ambitions. But do you think that these 'quiet revolutions' add up?

Not only do they add up, by themselves they can also have effects that would put some of the big macro reforms to shame. Consider the impact of de-worming, for example. The 20 per cent increase in wages resulting from de-worming is more than the effect of many years of wage growth in a country like Kenya. There is an easy confusion between "big questions" and "big answers". It is not that because the problem of poverty is large that the solution also must be large.

You say in the book that it is possible to improve governance and policy without changing the existing social and political structures. Aren't you running the risk of enraging mass movements across the world currently engaged in those very transformative processes?

We are not saying that you cannot change the world through a revolution. Just that really transformative revolutions are few and far between, hard to predict, and even harder to engineer. The question is, what do you do while waiting for the revolution? Is there anything useful we can do? What we are pointing out is that there are lots of changes that can happen at the margins, within the broad institutional structure that is in place. It is also possible that these changes can pave the way for more. We show that simple interventions can affect the way people vote, for example, making them more likely to vote on issues and less likely to vote according to ethnicity or castes.

You say that the poor often take bad decisions, but the richer you get, the more 'right' decisions have already been made for you.

Our point is that people in rich countries (and also rich people in poor countries) should become aware of something that they generally ignore about the poor: that the poor actually bear much more responsibility for many aspects of their lives than the rich. If you are poor, you have no water at home, let alone clean water. If you are rich, you can just open the tap and get clean water. If you are poor, you don't have a salary, you are selfemployed, or a casual worker. You worry everyday whether you will earn enough to feed your family. You have no safe place to save. All of this makes their everyday life so much more stressful that it is no surprise that the poor don't always make correct decisions. No one in that position could. It is possible to make life easier for the poor by trying to make the 'right choices' the easier ones.