Printing notes is no way out of trouble

Dear M,
Hey, I miss discussing the financial crisis with you. Tried calling, but couldn’t get through. So this email.

The times are getting even more interesting, you know. Several hallowed American companies are going down the drain, literally.

American International Group (AIG) recently announced that in the three months from October to December they made a loss of $61.7 billion. Now that is a lot of money to lose, Rs 3,17,755 crore to be very precise (assuming $1 = Rs 51.5).

The US government had given $133 billion to AIG in the past, but that doesn’t seem to have helped. So, AIG is getting another $30 billion. General Motors (GM), which reported losses of $31 billion on sales of $149 billion, has seen sales fall to a 27 year low.

GM got a $13.4 billion bailout from the government, and now wants $16 billion more.
Citigroup isn’t in good shape either. So are Fannie Mae, Freddie Mac and all those big financial institutions, which have had to be rescued by the government.

This is not the case with the US alone. Various countries in Europe have gone around rescuing their once hallowed financial institutions, too. But neither in the US nor in Europe has any of these rescue efforts borne fruit so far. The losses keep piling up, questioning the very basis of bailing out the financial institutions in the first place. Should the market be allowed to work, and these institutions allowed to fade away? I wish I had an answer to that.

And I need not tell you where all this money is coming from. Various governments are printing all the money they need. Okay, I can see you raising an eyebrow. How do I know this? Oh, it’s rather simple. When a government wants to borrow, it has to issue bonds. Investors like banks and other financial institutions invest in those bonds and thus the government gets the money. Basically, the money the government borrows comes from the money supply already available.

In the recent past, the US government has injected nearly $300 billion into the financial system, without there being a similar increase in the bonds issued by it. Basically, therefore, all this money is being created out of thin air — it is being printed. And the US isn’t alone. European countries such as the United Kingdom are also doing this.
The money being printed is used to keep the weak financial institutions, which would otherwise have gone bust, up and running. It is also being used by governments to spend on what are being referred to as “shovel ready projects.” The idea, as I have explained in the past, is to get the banks to start lending again so people borrow and spend it.

This will lead to the moribund economy growing again. The “shovel ready projects” are expected to put people who have lost employment back on job and earning again. Earning is likely to lead to spending and hopefully, this will revive the economy.
But all that is theory. Will it practically work out the way, as politicians and economists have been saying it would? Highly unlikely, if history is anything to go by.

Money printing only leads to more money printing. Okay, don’t you raise that eyebrow again. I’ll explain.

When a spate of money suddenly hits any economy and people go out and spend, it leads to increased prices. The supply of goods and services they want to buy cannot suddenly expand to keep up with all the newly created “paper” wealth. So suddenly, there is a shortage of goods and services, and this leads to increased prices or inflation, as they call it. When an item is available in abundance, its value tends to go down and vice versa. All this printing of currencies will lead to a situation wherein the purchasing power of currencies will continue to decline. This would mean even more currency will have to be printed, which could lead to hyperinflation — a situation where prices go totally out of control, as the currency rapidly loses value.

Take the case of Zimbabwe, which has been printing Zimbabwean dollars for sometime now. Economists estimate that the rate of inflation is currently at 5,000,000,000,000,000,000,000 (five sextillion) per cent. The country recently even printed a 100 trillion Zimbabwean dollar note, which was just about good enough to buy a loaf of bread.

Basically then, the Zimbabwean dollar as a currency has totally collapsed. And this phenomenon gets repeated time and again. As Puru Saxena, a Hong Kong-based wealth manager writes, “In fact, a remarkable study confirms that only 23% of paper currencies ever issued have survived the test of time.”

And why isn’t all the money being printed in the US and Europe not showing up in inflation? It is primarily because the banks are not ready to lend now, as they don’t have enough confidence in the ability of borrowers to repay in such an economic environment. But you need to remember that gradually most banks are being nationalised. Take the case of Citigroup, up to 36% of it is owned by the US government.

A lot of banks in Europe have been nationalised or are in the process of being nationalised. Once the government takes over, it will ensure that the banks actually go out in the market and lend all that money that has been printed up. If that happens, inflation is going to go through the roof.

By printing all this money, the US can hope to inflate away all its debt. The US currently has a total debt of $54 trillion, which it cannot repay in the normal scheme of things. “In other words, either the US will default (highly unlikely in my view) or it will print and inflate so that this huge mountain of debt feels much smaller in the future due to the loss of its purchasing power,” writes Saxena.

And who loses out in such a situation? Countries like China, Japan and the oil producing nations who have a lot of their foreign exchange reserves invested in bonds issued by the American government.

If all this printing continues, economies are likely to see hyperinflation in the day to come and their currencies will be in trouble.

“As the jokers in Washington continue to ‘save’ the US economy (i.e. bail out their rich friends on Wall Street), the US dollar will eventually become worthless or it may be replaced by another currency.”

Hope I haven’t scared you too much. Such are the times.
Take care.
V
(The example is hypothetical)