The BSE Sensex has been surging, breaching all-time high levels several times over the last year and trebling since 2009. The rest of the economy – in terms of industrial production, employment and exports – do not yet reflect the same strength.

Markets around the world have been similarly robust. The US Dow Jones doubled in six years, reflecting annual growth in excess of 10%. UK’s FTSE has increased by roughly 50% during this period. According to World Bank data, market capitalization of all listed companies around the world surged from $34.8 Trillion in 2008 to $54 Trillion by 2012. But globally, as in India, industrial production has lagged behind.

Some valuations – like those of Tesla or Google – reflect technological enhancements and productivity improvements. But much of the strength in the stock market maybe explained not by growth but due to Central Banking policy.

Last month, for instance, Mario Draghi, president of ECB, threw his hat into the ring of central bankers attempting to douse the economy with a gush of cash when he committed the Eurozone to a quantitative easing program of at least $1.3 Trillion. This policy tool, almost unheard of till 2008 and not yet a part of standard economics texts, has been the favoured weapon to shore up the economy.  It comprises electronically generating new money to directly acquire financial assets – really a steroid shot when standard central bank tools, like interest rate adjustment, do not revive growth. So much new money has been introduced into the system using exotic means that since 2008 the assets of major central banks (Eurozone, US, Japan and China) tripled to $13.9 Trillion. The easy money policy is akin to adding the total money supply of India ($1.6 Trillion as of December 2014) each year for eight years.

When money supply increases, initially more currency chases the same goods and services, and prices increase.  This is accompanied by a lowering of interest rates, which makes consuming and investing cheaper, so output should also rise. Higher output increases need for workers, pushing up wages. So, conventionally, higher money supply raises prices, wages and output. Uncontrolled increase of money supply can cause spiraling inflation. To cite an extreme example, prices doubled every 3.7 days in the Weimar Germany when the Reichsbank rapidly increased money supply in 1923. Some commentators speculated that QE would also have a large impact on inflation. But seven years after the launch of QE, prices around the world have hardly budged. In 2014 inflation was 3.9% globally and 1.7% for developed economies.

Sticky prices may have been caused due to several factors. Since 2000s, capacity buildup in countries like China meant production of goods could be increased without adding fixed costs or raising prices. Similarly, with improved connectivity, purchasing goods and services can occur virtually, and across international borders. Access to additional vendors allows a potential consumer to shop around for better prices, which has a moderating impact on inflation. Moreover, productivity enhancements augment output that can match, and exceed, existing demand. For instance, in the mid-1960s in India, food-price inflation was mitigated due to productivity enhancing innovation such as fertilizers, mechanization and higher yielding varieties of seeds. Without these enhancements, supply of food would be lower, and inflation would be higher. Similarly, improvements in analytics, communication and mobility have enhanced workplace productivity in the last decade, and have had a dampening effect on prices. But mainly, the reason inflation has been low is because additional currency did not primarily chase goods and services in the first place, it mostly went to purchase assets, and mainly liquid financial assets like stocks. So, while there was an asset (stock) price inflation, inflation in goods has been limited.

For the same reasons – labour saving technology in services, and off shoring of manufacturing to lowest wage cost countries – the surge of liquidity hasn’t caused wages to shoot up either. ILO’s Global Wage Report in 2012-13 shows that global monthly wages grew by only 1.2 % in 2011, down from 3% in 2007 and it remained at 0% in developed nations.

So, the largesse of the central banks have flowed into the stock market and thus into the publicly listed companies. Companies are in a position to swap their stocks to acquire other companies or make investments. In India some of this fund flows in as foreign portfolio investments whose stake in BSE listed companies is at a ten year high. Can the goal of economic revival be achieved by funding into these company’s stocks? It can, if the firms invest the money to grow – by building additional factories, recruiting more staff and introducing more products. If they did, it would be answering the call of the central bankers – capital investments would revive demand, recruiting would increase employment and the economy would be chugging along. But most firms didn’t invest. William Lazonik of University of Massachusetts found that US companies used 54% of their earnings to buy back their own stock, increasing their share price, and most of the rest was paid out as dividends leaving little for investments in capital or in employment. That is, while the firms had money, they did not contemplate that in an economy where demand is weak, building more capacity or hiring more people would be wise. No firm will manufacture more goods unless there are buyers willing to buy, notwithstanding the availability of funds. Thus, most of the funds remain as cash in their books.

Thus while the central bank policy has helped increase stock price, it has not had the same inflationary effect on the rest of the economy. Now, as some central banks, notably the US Fed, reduce or eliminate the asset purchase policy, stock markets may swoon. This drop of share price every time central banks taper asset purchases already has a moniker – it is called taper tantrums.

Ultimately, central banks have limitations, even though their power has vastly expanded in the past fifty years. In the early parts of the twentieth century, central banks only issued currency based on their individual gold reserves.  This kept a leash on their balance sheets. Having been freed from those shackles, they have greatly increased money supply, and much good has resulted – the world economy would have been a fraction of today’s size if the gold standard was maintained.

However, economic policy still primarily depends on the statesman, and not the banker. And it is a testament to global weak governance that in no country bold economic policy is seemingly possible. China, as a one party state, could confidently build infrastructure that aided growth, but it has been stymied by weakness in soft infrastructure – establishing legal and property rights, transparent banking procedures for appraising loans – that are equally important for an economy.

In emerging market democracies like India, fiscal policies are therefore critical and are occasionally a bottleneck for development. For instance, India’s power consumption is still modest at around 600 KWH per person. Richer countries such as China (2,900 KWH) and Brazil (2,300 KWH) generate and use far more energy per person. To grow our economy, we need more energy to run our factories and transport our goods. But, government policies on coal sourcing, power distribution and pricing will have a bearing on whether the power required for India’s growth can be generated. Similarly, India’s complex land and labour policies hinder our economic performance, and fall within the domain of fiscal reform. Not only will these policies be welcomed by the stock market, they will also help in spreading the benefit to other sectors of the economy. Monetary policy alone cannot revive growth or enhance wages. Central bankers and the judiciary are mostly independent from the populist pressures that the executive and legislative sections of the state face, and sometimes is able to push through measures that are unpopular, but real reform will have to wait till governments ride their popular mandate to bring changes.  Let us hope the upcoming Union Budget is a step in that direction.


The Statesman | 24-Feb-2015

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