Last week we received what looked as a funny entertaining story at first, but it made us think about the true reasons behind it. Surprisingly this has been one of the topics we have been writing about recently and could not be more topical.
The story goes as follows:
In a small town on the South Coast of France, with the holiday season supposed to be in full swing, but unfortunately it is raining so there is not too much business going on.
Everyone is heavily in debt. Luckily, a rich Russian tourist arrives in the foyer of the small local hotel. He asks for a room and puts a Euro100 note on the reception counter, takes a key and goes to inspect the room located up the stairs on the third floor.
The hotel owner takes the banknote in a hurry and rushes to his meat supplier to whom he owes €100.
The butcher takes the money and races to his wholesale supplier to pay his debt.
The wholesaler rushes to the farmer to pay €100 for pigs he purchased some time ago.
The farmer triumphantly gives the €100 note to a local prostitute who gave him her services on credit.
The prostitute goes quickly to the hotel, as she owed the hotel for her hourly room use to entertain clients.
At that moment, the rich Russian is coming down to reception and informs the hotel owner that the proposed room is unsatisfactory and takes his €100 back and departs..
There was no profit or income. But everyone no longer has any debt and the small town people look optimistically towards their future.
At the end of the e-mail they raise the question whether this could be the solution to the current crisis. Or is there a catch 22?
Unfortunately indeed there is. Over the last couple of months we have been writing about quantitative easing and the central banks who need to take over the Shadow Banking system as without them the money supply, M2, would collapse which in turn has a negative impact on economic growth.
Remember our equation: GDP = M2 * V
In the example above the Russian tourist plays surprisingly the role of central banker. It is obvious that growth in this cosy little village came to a standstill as their velocity of money turned to zero. The visit of our Russian tourist to the hotel could be seen as the central bank injecting extra money into the village’s micro economy, this to jumpstart the economy again.
The major problem in the town was that previously the inhabitants went on a spending spray and burried themselves in debt. The money injection from the Russian tourist triggered a deleveraging process, similar to what we are seeing right now among US consumers. People within the village also decided to pay off their debts first before they would start spending again.
This illustrates very well the limitations of central banks in generating growth in the current environment. As we previously noted, growth will only be achieved when V at least stays stable and certainly is not zero.
But there is even a bigger problem. At first sight, the story above looks like a happy ending. The hotel owner recuperates his EUR 100 note in time before the Russian tourist comes down from his inspection.
In the real world life is not that kind to us. Chances are high that the hotel owner spends the money again before the Russian tourist returns. In this case this would achieve the initial goal of the central bank, that is creating growth. This will create some new dynamism in the little village and as a result the butcher-farmer- etc will start to adjust their prices again.
However at a certain stage the central bank needs to withdraw the money it has injected in the system before as inflation starts to rise. And this is the moment when our Russian tourist comes down the stairs, and disappointed from the room he has seen, asking his money back.
The catch is that the central bank will come too late. Their track record in the past has been very poor in that matter. The mismatch in timing of monetary rate policy versus economic growth is something central banks always struggle with. If one compares the change in federal fund rates with the average growth rate in GDP terms during the previous two years one gets a clear view of the overshooting of monetary policy of the Fed.
Figure 1: 2 Year Nominal GDP Growth versus Fed Fund Rates 1960 – 2008
Source: Bloomberg data
As Figure 1 clearly shows this was not a one off incident. In 1974 the Fed cut rates aggressively from 10.5% to 5 % over a period of 2 years. In the second year though the economy was already taking off again and the Fed wanted to catch up their previous monetary easing which contributed to the banking crisis of the eighties. The central banks intervention can almost be compared with a pendulum which goes from one extreme to another. The major reason behind this mismatch in timing is the lack of focus by central banks in monitoring asset price developments in the price indices.
Going back to our story, the Russian tourist does not pay attention to what is happening with his EUR 100 note while he is inspecting the room upstairs either. By default he comes downstairs and assumes the money is still there.
Unfortunately in our example the money will be most probably gone. We have all read stories in the press on how Russians are keen on recuperating their money and what happens to the people involved when they can not pay them back. We certainly will not envy our beloved hotel owner as he will face some very rough times…
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