Why printing money is simply not working

Last updated on: September 29, 2011 11:02 IST

My roommate, as usual, was short on money.

"Can you lend me a thousand quid?" she asked.

"Quid?"

"Rupees! I am sorry I keep borrowing money from you all the time, but one day I am going to return all your money," she said confidently.

"And just how do you plan to do that?"

"Well, I'll print it!"

"Oh, so you have plans to go to jail?"

"Why will I go to jail?"

"Well, for the simple reason that the government has the exclusive right to print money. And you and I and anybody else can't do it."

"Anyway, now that we are talking about money printing, I have a question. You know we have been talking about quantitative easing for a while now, but we haven't really gone into it in depth. Could we talk about that today?"

"Yeah. Sure we can."

"So how did it all start?"

"Sometime in September 2008, the investment bank Lehman Brothers went bust and the insurance company AIG was also on the verge of going bust. After that the US Federal Reserve decided to reduce short-term interest rates to almost zero per cent. Other than that it also decided to print money, technically which this came to be referred as quantitative easing, or QE."

"But how does this work?" she asked.

"Basically what the US Fed does is it buys various kinds of financial securities issued by the government as well as government-owned companies from financial institutions and banks. When it does that, it pays the financial institutions and banks which sell these securities to the Fed."

"And to buy these securities, the Fed prints money?"

"Yes it does."

"But what's the idea here?"

"Well, the idea is that when banks and financial institutions sell financial securities back to the Fed, the Fed pays money to them. This is done in the hope that banks and financial institutions will go and lend this money to borrowers who are willing to borrow. When people borrow they use that money to buy things. This in turn means more money earned by corporations, which in turn means they will recruit more people, who will spend more money and so on."

"Yeah, this you have explained to me before."

"Nearly 70 per cent of the US gross domestic product comes from consumer spending. And a lot of this spending happens from borrowed money. Now that is not happening right now. As Gary Shilling writes in a recent report, 'It requires the cooperation of the banks as lenders and the creditworthy borrowers to turn those reserves into loans and money. But banks and borrowers have been reluctant to do so'."

"So the government can just print money, it is then up to the banks to lend and the borrowers to borrow," she summarized.

"Yes, you are right."

"And that is clearly not happening!"

"Yes ma'am. Banks had gone into a lending spree and gave out loans to almost anybody and everybody, till a few years back. Something that led to the financial crisis. Now they are willing to lend only to people who have good credit ratings. But those guys really are not in any mood to borrow. As Shilling puts it, 'Creditworthy individuals are also reluctant to borrow, and instead are paying down their mortgage (home loans) and other debts'."

"So where did all this money go then?"

"Well, nearly $2.3 trillion was printed and used to buy financial securities. And of this nearly $1.6 trillion of this lay sitting idle on the reserves of banks. A lot of this money simply went into the dollar carry trade."

"Dollar carry trade? What's that?"

"Since the interest rates in the US were almost close to zero, investors borrowed that money and invested it in stock markets and commodities across the world. And that's why oil prices have gone through the roof. And that's why the Sensex rallied from a low of around 8,000 to a high of nearly 21,000. That also led, to a large extent, to the prices of commodities like gold, silver, soybean, corn, etc going through the roof."

"So it's QE money that has been driving all the rallies!"

"Yes. And in the latest Fed policy, investors were expected another round of QE, which they did not get. As investment letter writer Gary Dorsh writes in his latest column, 'Once the printing presses turned silent...the QE addicts on Wall Street began to suffer from severe withdrawal symptoms. The stock market bulls suddenly got wobbly knee caps'. Also with no QE in sight, gold prices also fell."

"Hmmm. That explains things to a large extent," she remarked.

"Also the environment is such that people are not interested in taking any risk. As Dorsh writes, 'The vast majority of the US-public has lost faith in Wall Street, and has withdrawn about $2-trillion from the stock market. Instead, it is estimated that the wealthiest 10 per cent of Americans are now left in control 80 per cent of the outstanding stocks. Furthermore, nearly 60 per cent of the trading volume on the NYSE and Nasdaq is now handled by high frequency computerized Black Box traders, and in the first half of August, they accounted 75 per cent of the volume'."

"Oh. Is that the case?"

"Yes and, because of that, a lot of money is simply moving into bank deposits. 'US banks are paying almost nothing for deposits, which continue to rise in a mad stampede for safety and liquidity. Since December 2007, domestic deposits have leaped $1.1 trillion to $8.1 trillion. Indeed, Bank of New York Mellon last month began charging a fee for corporate cash deposits of over $50 billion, and others may be contemplating similar moves,' writes Shilling," I said.

"Now that surely is interesting. Banks charging money to accept deposits. Never heard that before," she replied. "But what about corporates how well are they doing?"

"Surprisingly, they are doing pretty well. Especially if you don't take the banks and other financial institutions into consideration. 'US-corporate profits have more than doubled from the depths of the Great Recession, to an annualized rate of $1.54-tillion in Q'2 of 2011. Corporate America's cash stockpiles are at all-time highs and its balance sheets are in much better shape now than at any time in the past decade. Google announced Q'2 net income of $2.5-billion and Apple made $7-billion, nearly doubling its earnings from the same period a year ago,' writes Dorsh."

"Oh, so they are sitting on a lot of cash?"

"Yes, they are. And a lot of this cash has been generated by firing nearly 8.4 million workers. And despite doing reasonably well they are not in the mood to hire more people primarily because they are not sure when the bad times will end," I explained.

"You know, the only thing I am sure of is that we are going to have many of these conversations in the days and even years to come," she said.

"As the old Hollywood line goes, 'you ain't seen nothing yet!," I remarked. "And of course if we continue to stay roommates."

"Why are you thinking of moving out?"

"Well, the rate at which you are borrowing money, I just might!" I said, having the last laugh.