“Nobody borrows like us... nobody spends like us... and nobody prints like us.”

Fed Reserve under leadership of Ben Bernanke is busy in devising strategies to combat one of the most severe recessions US has ever faced। BB is busy printing currency; what is the rationale behind this. Let’s figure this out.

Throughout 1990’s US had been growing at spectacular growth rates as compared to its peers. US has been the growth engine of this world economy. Consumers in the world largest economy were confident of their future incomes and this certainty and their confidence could be seen in their consumption patterns. Throughout the 1990 decade, the US households have been associated with investments exceeding savings and their consumption exceeded their incomes. Animal spirits and interest rate stability further boosted the growth. Since US had a very high income elasticity of imports and on other hand a very low income elasticity of its exports, it lead to a continued trade deficits. This made US very attractive for foreign investors, who were willing to make a quick buck in the oasis of prosperity. The slowdown in Euro region and negative growth in Japan and string of events like defaults in Mexico, Russia, South East Asian crisis made money looking for safe heaven reach US securities and the increased capital inflows affected the trade flows and dollar appreciated there by harming the relative competitiveness of US exports.

One important lesson to be learned is: be it government, household or firms...they often don’t realize they might land into deep troubles by indulging in excessive consumption. There should be some mechanisms to check their spending whenever the capital markets are too willing to lend money. Because the demand for assets to a large extent depends on the expectations of risk and return expectations. Any changes in these expectations could severely impact the demand for an asset.

USD has been the reserve currency since long and US denominated debt was always considered as risk free and investment grade. Moreover, appreciating USD gave more incentives for people to invest in US financial securities. Growing US international debt reflected the confidence the investors had in the world largest economy and its productivity and on its ability to make the right use of the money. The capital inflows will continue and US can run a trade deficit as long as it services its debt and as long as US assets deliver higher risk adjusted return compared to their counterparts. The day, the investors feel, that US is incapable of servicing its debt and there is probability of default, there would be dramatic and abrupt changes in the portfolio composition which could influence the value of USD, growth, employment, household consumption and hence savings.

The Fed’s policy of aggressive printing currency will lead to depreciation of USD in forex markets. This is expected to accentuate the BOP situation in short run but in the long run US is expected to benefit from export of services, primarily because income asymmetry faced by US is low as compared that of goods. And other reasons are liberalization of services sector throughout the world and competitive of US services industry. The income asymmetry may be explained by composition of its population, immigrants etc who continuously make unilateral payments to their relatives in home countries etc.
Moreover, Fed may be attempting to reduce the impact of high debt on the consumption patter of US households. When the interest rates rise, the PV of debt increases, which in turn requires the households to make extra provision for increased debt, which in turn reduces their consumption.

US debt is dollar denominated, so when USD depreciates compared to GBP, Yen, Yuan etc, the foreign debt reduces. This is turn will reduce the pressure on US households.

Thirdly, when the government prints currency it raises the inflationary expectations. This clearly affects the real interest expectation; any changes in real interest influence the investment demand, When the real interest are low, investment demand will increase and thereby help in stimulating the economy and provide employment.

But the most important question is who will fund this investment. In past, strong capital inflows supported the investment demand. But, with such large bail out plans, probability of default increases and this source of money will no longer exist. And considering the past trend in domestic savings, I really doubt whether households can save enough to tide over this problem.