Monday, May 13, 2013

Simple Nostrums For Complex Interactions: Details Matter

I'm quoting more than I usually do, because there are quite a number of fallacies to be addressed here (excerpt):

Rising tides of currencies globally

A PACKET of nasi lemak (rice cooked in coconut milk) with a fried egg costs around RM2 nowadays. I remember getting a similar packet (and in bigger portion) at RM1 ten years ago. It is a 100% price appreciation in ten years! My friends and I were jokingly saying that nasi lemak would be a good investment tool if it can be kept for ten years...

…The global economies have been embarking on expansionary monetary policies since the financial crisis broke out in 2008. Central banks around the world are printing money to support their economies and increase exports, with the United States as the primary instigator.

Since 2008, the Fed initiated several rounds of measure termed “Quantitative Easing”, which is literally known as an act of money printing. The Fed's balance sheet was about US$700bil (RM2.1 trillion) when the global financial crisis began; now it has more than tripled. With several countries' central banks including the European Central bank, the Bank of Japan and the Bank of England taking similar expansionary measures and encouraging lending, more than US$10 trillion (RM30.3 trillion) has been poured into the global economy since the crisis began.

While the global central banks have become addicted to open-ended easing and competed to weaken their currencies to boost economies, the impact of these measures to the global economy is not quantifiable or realised yet. However, basic economic theory tells us that when there is too much money chasing limited goods in the market, it will eventually spark inflation.

When money is created out of thin air, there is no fundamental support to the new money pumped into the economies. More money supply would only be good if the productivity is going up or in the other sense, when more products and value-added services are created. In the absence of good productivity, more and more money would not make people richer. Instead, it would only decrease the purchasing value of the printed notes.

Let's imagine a more simplified situation. For example, we used to purchase an apple for RM1. If the money supply doubled but the amount of apples available in the market remains, one apple will now costs us RM2 instead of RM1. Now, our money has halved its original value. If the central banks of the key economies keep flooding the global markets by printing more money, the scenario can only lead to the worst, i.e. hyperinflation.

This occurred in Germany after the First World War. Hyperinflation happened as the Weimar government printed banknotes in great quantities to pay for its war reparation. The value of the German banknote then fell since it was not supported in equal or greater terms by the country's production…

…With Malaysia's current economic and population growth, added with its still comparatively low property prices in the region, our primary and secondary market properties are good investment assets for investors to gain from the continuous capital appreciation that this industry is enjoying.

With the above as a backdrop, are property prices really going up globally?

Using the nasi lemak analogy, if we were to buy a RM100,000 medium-cost apartment 10 years ago, it would be equivalent to 100,000 packets of nasi lemak. Assuming it has doubled in price today, it would still be the equivalent of 100,000 packets of nasi lemak at RM2 today. It would seem to me that the true value of properties hasn't gone up, but that global currencies have just gotten cheaper.

Issue: If inflation and hyperinflation automatically follow on from printing money, why is global inflation so low?

But let’s take this argument apart piece by piece.

First, there’s an underlying assumption that central bank money creation is the basis of all increases in the money supply. This is untrue – under most circumstances, money creation is the sole preserve of the financial system, not the central bank.

Secondly, there is an even more basic assumption that money, once created, continues to exist in perpetuity. That’s not true either – money growth (and I don’t mean notes and coins) and its velocity expands and contracts with economic activity. Money is destroyed and wasted on a daily basis.

Third is the assumption that money creation is facilitating a condition of an excess of aggregate demand over aggregate supply, which would be a necessary precondition for prices to go up. Strike three – with unemployment above long term norms in much of the developed world, the idea of demand outpacing supply is ludicrous.

The only situation where money printing leads directly to inflation is in an economy that is already at the limits of its productive capacity, and where newly created money is immediately spent, for example where there is direct monetisation of government spending, i.e. the government borrows directly from the central bank to finance its spending. Quantitative easing might look the same, but functionally its very different.

To make all this stuff clear, let’s complexify the example used. The money supply is RM1, and 1 apple is the only good available in the world. I borrow RM1 from a bank to invest in an orange orchard – the money supply is now RM2 (RM1 loan + RM1 cash = RM2 deposits). Does this increase demand price pressure? No, because I’ve introduced a capital good into this hypothetical world (land for the orchard). But possibly yes, if that money was redirected towards consumption instead of investment.

But people want apples, not oranges, so my business goes bust. The bank that loaned me the money is now insolvent, because it now has twice as much liabilities compared to its assets. The central bank then prints RM1 to fill the liquidity/solvency gap, which preserves the assets of the bank depositors. But the money supply doesn’t increase in this case – it’s just status quo ante. There’s no extra money chasing the apple and the land.

To spell it out: loans and credit arrangements are forms of money creation; debt repayments and debt defaults are forms of money destruction.

You could argue that the original monetary expansion arising from the orange orchard was misallocated – but that risk is a normal part of any economic expansion or business venture.

The point is, in a situation where asset prices fall below the level needed to back the debt used to purchase them, adding liquidity won’t add to price pressures – the money created just fills up the hole left by the money destroyed by debt defaults. When companies and households repair their balance sheets by paying down debt, that implies a monetary contraction, unless new loans are given out or the central bank adds liquidity. When suppliers start demanding payment in cash rather than giving credit terms of 30 days or more, that too implies a kind of monetary contraction.

Under those circumstances, money printing under the guise of quantitative easing isn’t going to be inflationary. Hyperinflation? Perish the thought.

Turning to the Nasi Lemak issue, here’s where the analogy fails (index numbers; 2000=100):


Food price inflation has been systematically higher than overall inflation, and much higher than non-food, non-transport inflation. Overall food prices are currently nearly 50% higher than in 2000, compared to just 20% higher for core inflation. But house prices have increased much more steeply since 2008 – 35.9% up to the end of 2012, and that’s just the average. In some spots, the increase has been even more drastic.

I’m afraid Datuk, that it will take much more than 100,000 packets of Nasi Lemak to buy that apartment now.


  1. I'm always leery when property developers start dabbling in economics to justify why we should be buying more property

  2. "The only situation where money printing leads directly to inflation is in an economy that is already at the limits of its productive capacity, and where newly created money is immediately spent, for example where there is direct monetisation of government spending, i.e. the government borrows directly from the central bank to finance its spending. Quantitative easing might look the same, but functionally its very different."

    As long as aggregate demand is lower than aggregate supply, I don't think that it makes any difference for a gov to fund her deficit either through borrowing or direct monetisation.

    QE is a direct monetisation process, unless you want to reclassify the direct monetisation as a money printing process only when the economy is running at/above its full capacity.

    1. ET,

      I would define direct monetisation as money printing that actually finances current government consumption and investment. The way QE is done, the new money flow is neither direct nor automatically spent.

      Given the mechanisms involved (IOR in the US, full sterilisation in Europe), there's not much of a link with current or past government spending either. In theory, the impact of QE under these conditions should largely be through the interest rate channel, rather than a direct boost to aggregate demand.

  3. Morning Hishamh,

    If it was not printed then where are the money went, and Brazil and some countries complained that there were a lot of money (US$) causing their money to appreciate, etc etc

    Zuo De

    1. Zuo De,

      Due to IOR and sterilisation, plus private sector desire for safe assets, most of the new money created by the Fed, ECB and BoE are sitting right where they started - at the Fed, ECB and BoE. Increases in excess bank reserves kept at central banks have increased almost proportionately to QE asset purchases.

      Most of the capital flows coming into emerging markets is therefore due to portfolio rebalancing, as investors respond to lower long term yields in advanced economies.

  4. Wait till you read this:

    1. O h...M y...G o d

      #$%&#@* Austrians!

  5. So, Hisham - if what you postulate is correct, the massive inflows that emerging markets were expecting from QE and monetary easing by the ECB and the BOJ were merely figments of imagination dreamed up by overpaid analysts and economists?

    Which means that all that wealth sloshing around in financial centres and tax havens are not the results of massive monetary easing, but more attempts at tax avoidance or tax evasion by individuals and corporates.

    So, why ease at all, when the spinoffs to the "real" economy are disappointingly miniscule?

    And why run up deficit budgets when the spinoffs are also ephemeral?

    1. @TamanTasek

      A few issues with what you are saying:

      1. QE by the major central banks over the past few years have not noticeably increased broad money supply growth in any of their economies. Also, much of the money that has been created through QE remains on central bank balance sheets - it hasn't gone anywhere.

      It follows therefore that the liquidity that has engulfed emerging markets is NOT due to an increase in money available for investment, but rather portfolio "rebalancing" - existing fund searching for yield.

      QE has the effect of raising prices (reduces yield) on advanced economy assets. As a result, hedge funds, insurance companies, pension funds etc with investment mandates to fulfill, have gone further afield to maintain their returns, which is what I took some pains to try and explain in my latest post.

      2. Money is NOT equal to wealth.

      3. Budget deficits are composed of the difference between two factors - revenue and expenditure. When your economy isn't doing well, guess what happens to revenues?

      4. Why ease? When times are bad, demand for "safe" assets such as cash or near cash equivalents escalates e.g. US Treasury bonds. For instance, when the US government and Congress were deadlocked on spending cuts, and the government was nearing technical default, demand for US Treasuries actually rose. Unless this demand for safe assets is met, neither investors nor borrowers would be willing to take risks like expanding production or spending or hiring.

      Question: What do you think would have happened to the global economy if there had been no QE? If you say nothing, I'd like to introduce you to the idea of counterfactuals.