QE, Inflation, And The Case For Precious Metals

March 13, 2012

Avery Goodman





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The Wall Street Journal published a fascinating article concerning the latest thinking going on at the Federal Reserve. The article is penned by Jon Hilsenrath, a Journal author who seems to have good sources at the central bank. He is usually in-the-know when it comes to Fed-think. Hilsenrath writes:

Under the new approach, the Fed would print new money to buy long-term mortgage or Treasury bonds but effectively tie up that money by borrowing it back for short periods at low rates. The aim of such an approach would be to relieve anxieties that money printing could fuel inflation later, a fear widely expressed by critics of the Fed's previous efforts to aid the recovery.
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What more brilliant scheme could the Federal Reserve come up with? First, print up wads of money out of thin air to buy bonds. Second, suck in an equal amount of money from the rest of the economy. Third, place that sucked-in money into reserve "term deposits," making certain that not one dime ever reaches the pockets of the masses. The end result? No inflation, and all money ends up in the electronic pocketbooks of Federal Reserve primary dealers.


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Admittedly, as the newly printed money makes its way to the primary dealer pocketbooks, it does stop, for a while, in the pockets of bond owners and issuers. The government is one of the big issuers, so it gets to have its deficits monetized. Monetization placates those politicians who like to spend without paying for the spending, and this aspect of the plan will stop them from taking any action to shut it down.


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Big companies that can issue bonds will also receive money for a while, at very low rates, because so many bonds will be bought by the Federal Reserve and, until the Fed becomes thoroughly discredited as an institution, artificial shortages will raise prices and reduce yields.


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Big banks who are the underwriters or issuers of corporate, securitized, and/or other debt paper, will sell bonds for artificially inflated prices. They'll also be able to sell and/or value existing bond inventory at higher prices, at least for a while. The investment banks, who trade stocks, bonds and commodities, and are also the primary dealers, will be flush with cash to use in speculative activities. So, stock prices will be supported. But money that would otherwise be inside the real economy, will be extracted, removed by the Fed.



In reverse repo operations, a central bank sells assets such as Treasury securities for cash, and agrees to buy them back later at a slightly higher price. This removes money from the financial system. In the past, reverse repo operations have been done almost exclusively with the Federal Reserve's primary dealers. But, on February 1, 2011, the Financial Times reported that the New York Fed, which runs all market interventions, was expanding its operations to include small entities with net assets as low as $5 billion. Smaller banks and other financial entities, which normally supply loans to small to medium sized businesses and average citizens, are going to be participating in the reverse repo operations.


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The USA is in a severe economic downturn, and a depression mentality has taken hold. Economists tell us that the so-called "velocity" of money has deeply fallen, and that less money is greasing the wheels of industry. Some Keynesian-oriented economists go further, and say we must print new money, even out of thin air, in order to offset this shortfall of cash. Otherwise, they claim, business activity will fall, plants and factories will close, and people will remain out of work. But, the Fed will now be filling the coffers of primary dealers and government, while draining the coffers of middle America. The financial "butter" mysteriously disappear from tables across Main Street, even as it overflows the tables of Wall Street. Small to medium-sized business happen to collectively employ a vast majority of Americans. Unemployment will soar under the Fed plan.

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Beyond this, how in the world can quantitative easing be negated by reverse repo operations, and be useful in stimulating the economy? This author vociferously disagrees with most of the principles of the Keynesian school of economics. In truth, government spending does not restore economic activity, except in an unsustainable fashion. Only trust in the system, and the desire to work hard and produce, which arises out of it, restores the economy. Thus, true economic recovery can only be achieved, in the long run, through the use of honest money. Fiat cash, printed and given away to friends of modern-day Mandarins, at the Federal Reserve, will lead to ruin.

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Unfortunately, the Federal Reserve's Mandarins are fervent believers in Keynesian doctrine, and they have already printed trillions of new dollars. They propose to continue printing money, but now want to "offset" the printing, "to lower inflationary expectations" by taking money out of circulation. No more irresponsible plan could ever be conceived. It is logically impossible for the newly printed money to have any effect on the fall in the velocity of the old fiat money if an equal amount is consistently removed.

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Sterilized quantitative easing cannot, by definition, replace the lost velocity of the money supply and, therefore, it cannot "stimulate" the economy even by Keynesian standards. It cannot replace credit money that is being "destroyed" in the real economy, as debt defaults and non-payment problems mount. These are fundamental truths that do not change, even if we accept every principle of Keynesian economics.

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Why, then, is the Fed keen to embarking on a course of action that cannot possibly help the economy? Bernanke must have been lying when he told us that quantitative easing is a "tool carefully designed to help stimulate the real economy." If he were telling the truth, no one would propose sterilizing the alleged stimulation. But, then, maybe, the economy longer needs to be stimulated? If that were the case, there would be no suggestion, and no excuse for embarking on any form of QE, sterilized or not. Yet, the Mandarins are proposing sterilized QE and saying it will help economic growth.

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To understand requires an analysis of the true reasons for money printing, rather than the propaganda surrounding it. Ignore what Mr. Bernanke and the Fed tell us, and concentrate on the effect of what they are doing. Quantitative easing is financial repression. It is a method of shifting assets from one group of people to another. In this case, the people on the receiving end are mega-bankers and the government. Mega bankers use newly printed cash to speculate, and to paper over holes in their balance sheets. The government uses the money to pay its bills.


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King George III of England tried out financial repression a long time ago, but was unfortunate enough not to have his own version of Ben Bernanke, back in the 1770s. To raise money, he imposed overt taxes without consulting the legislatures of the States. Our great nation, the United States of America, was born out of a violent revolution born of a tax revolt. The Fed Mandarins learned a lesson from that episode in history. Quantitative easing is financial repression -- a covert method of doing the same thing that King George tried to do overtly, so long ago.

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QE is a tax imposed by the central bank without consent of the legislature, which shifts wealth by debasing the currency in which the wealth is denominated. Proponents seek to avoid the desire for vengeance that naturally arises in the hearts of victims of theft by cloaking the scheme in a fancy name, and with a veil of deceit. For example, when Bernanke talks about QE and interest rate manipulation, he never fails to refer to it as "accommodation." But it is not accommodating anything. It is merely theft, nothing more.

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Both what King George tried to do, and what the proponents of QE are doing now, amounts to "taxation without representation." Enthusiastic supporters of Keynesian economics seek to transfer the value of money from middle America, and specifically from people living on fixed incomes, to the government and the biggest banks. A majority of vociferous proponents, of course, are on the receiving end. They expect that they will succeed, where the King failed, because average Americans have no understanding of economics, and don't even know they are being screwed.

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Printing money avoids the political problems of more honest forms of taxation. It takes the taxing power away from the legislature, where the Constitution put it, and puts it in the hands of banks, whose former executives and independent contractors now serve as Mandarins of the Federal Reserve FOMC. Taxes are raised in a roundabout manner. Huge bond purchases are made by the central bank. This reduced the number of bonds in circulation, causing remaining bonds to become more rare, and more valuable for a while. Favored bond issuers and owners are relieved from the problem of searching hard for buyers.

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QE raises the value of favored assets, while lowering the value of disfavored assets (cash and dollar deposits). Losses that would, otherwise, be taken on investments in the free market are shifted from one group to another. Instead of bond values, for example, falling as the free market would dictate, bonds either stay the same or go up in value. Meanwhile, newly counterfeited money, printed under color of law, goes into circulation, causing an equal and opposite reaction in the value of cash. In short, the buying power of money falls. We see this in the form of higher gasoline and other prices.

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A fast falling currency is not a problem for those who hold the favored assets. These are artificially inflated, and the gains far outweigh the loss from currency debasement, because the cost of the latter is spread throughout the population, while the benefits of the former are targeted at favored financial institutions. The extra money received, above and beyond what the assets are really worth more than compensates for the decline the currency. Their bad business judgments and losses are thereby shared with the majority of completely innocent members of the public.

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Quantitative easing distorts the value of assets and inserts unfairness and inefficiency into the system. The fast falling buying power of the dollar, for example, along with artificially low interest rates are problems only to savers and bond buyers. They will pay more and get less than the free market dictates. "Crony capitalists," on the other hand, are greatly benefited. We end up with the most corrupted form of socialism, where the benefits of social assistance are restricted to the richest members of society. It is the worst of all the possible worlds, and the most destructive of all the "isms."

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In QE, the pre-existing money, which honest society believed would serve as a genuine store of value, is corrupted. That's how oil prices can skyrocket amidst a glut of supply. Quantitative easing helps bond issuers, bond owners (mainly banks and insurers), Fannie Mae, Freddie Mac, and the government. It hurts savers, bond buyers and most of the people trying to operate a business in the real economy, unless they are among those favored by the Mandarins at the Federal Reserve.

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Theoretically, in the case of non-sterilized QE, money can find its way downstream to the masses in the real economy. However, the Japanese experience, and the experience in America so far, indicates that this rarely happens. Counterfeited money generally stays inside the financial system, bloating up financial asset prices. It bolsters bonds, and temporarily pushes up stock prices, but accomplishes little else. But, sterilized QE is worse, because it provides no chance, whatsoever, for any money to make it into the real economy.

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Money will, of course, eventually make it into the real economy, no matter what the central bank tries to do. This will happen when it finally loses control over reserve deposits. That hasn't happened in Japan in 20 years, but Japan has, until very lately, been a nation with very high savings rates, and with a huge balance of trade surplus. America, in contrast, has a very low savings rate, and the world's biggest trade deficit. In the USA, if a large short term interest rate increase occurs, and that might happen if foreign central banks choose to keep fewer dollars, or the dollar loses its status as the main trade settlement currency.

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That is already happening in a minor way, and there is no reason to believe that the trend won't continue. In order to continue attracting term deposits, the Fed would be forced to pay much higher short term rates, or face the collapse of the currency. It will eventually be forced to print so much new money to pay interest, that high inflation is caused by the interest payments entering the money supply.

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In sterilized QE, the Fed will continue to print money and will give it to groups it favors. At the same time, it will also remove cash from the economy as a whole. That means that the most well-connected borrowers, including the government, and private players with close ties to the New York branch of the Federal Reserve (which does the interventions) will be supplied with cash. Investment bankers can use that cash to buy assets, including equities and commodities. If your connections are not so good, however, you depend on cash circulating in the system far from Wall Street and that means you will be in a very bad position.

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Smaller, middle-American banks are likely to be buying term deposits with the Fed, tying up their cash. Wall Street investment banks, who will receive cash for mortgage securitized bonds, and those hedge funds closely related to them, will use the new cash to dabble in stocks and commodities. That will continue to drive up prices. But, most of the cash in our financial system, other than that doled out by the primary dealers, will be sucked up into Federal Reserve deposits. This can and will happen even as the dollar continues to be debased and loses buying power. In sterilized QE, the full value of the debasement will go entirely to the government and to primary dealers.

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Sterilized QE cannot stimulate the real economy, but it can and will distort asset prices. The new program, if implemented, will supply money to some market players but not to others. All forms of QE are actually a nice name for what is a legalized seizure of assets, but sterilized QE is worse. The printing of irredeemable fiat money out of thin air to enrich some and impoverish others, is a corrupt exercise arising out of the inability of human beings to control the temptation to take from others what is not rightfully theirs. Aside from being a form of theft, it breeds moral hazard, malinvestment and the specter of heavy inflation.

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Keynesian economists believe that an increase in the monetary base can stimulate the economy, and that the end justifies the means. Yet, because the money never can enter the system, "sterilized" QE is purely a bid to delay the inevitable collapse of the current Ponzi-like monetary system, by creating an even bigger Ponzi scheme. The US Treasury, Fannie Mae, Freddie Mac, private securitizers, and/or anyone else that the Fed Mandarins choose to buy from, benefit, but no one else does.

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In the real world, non-connected institutions will be slowly starved for cash because most of the cash in our monetary system will be directed at the government and the primary dealers who trade with the Fed. Short term interest rates are bound to rise, under such conditions, and primary dealers will be sorely tempted to take advantage of that rise. They will lend to starving middle American institutions at much higher short-term rates than the Fed will be willing to pay.

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That means the seeds of demise are built into the idea. When short-term interest payments become high enough, the newly created funny money will rush out, or the Fed will be forced to create more and more new money just to meet higher and higher interest payments. Either way, there will be heavy inflation.

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Sterilized QE accomplishes one thing better than anything else. It provides time for smart people to dump bond holdings. They can prepare for what is coming. But, what is coming? Sterilized QE is designed to monetize debt, and send free money to the government and to politically influential bankers. Some of the primary dealers, flush with cash, will turn around and buy term deposits at the Fed, but more savvy ones are going to be buying gold, silver and platinum getting ready for the final implosion. The Fed creates cash for the government and its private banking friends, while sequestering liquidity away from everyone else. The economy will NOT recover until these manipulations end. The increase in skepticism that they engender will have far-reaching negative effects. The multiple errors in judgment are piling up, higher and higher.

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Stocks will rise as long as the Fed is able to retain control. When control is lost, as it will be, look out below. Sooner or later, it is likely that stocks will start to lose nominal as well as real value. Yet, in spite of being sped along by "sterilized QE," the end still won't come right away. The scheme is a bit too open and obvious to fool people for a long time, but I have overestimated investor intelligence before. If the Fed succeeds in its latest shenanigan, precious metals prices may take a temporary dive, and that will provide another excellent opportunity to get rid of federal reserve notes and other doomed fiat currencies.



Gold and other precious metals are not merely bets on the likelihood of inflation, deflation and/or the "end of the world" scenario. On the contrary, it is a solid bet upon the likelihood that current foolish policy decisions will continue and/or become even more foolish. The Fed Mandarins, and their counterparts elsewhere, will continue to make the wrong judgments, until their actions finally implode the system. Ron Paul has noted, during the most recent confrontation with Federal Reserve Chairman Ben Bernanke, that "things appear to be coming to a head when it comes to the money. Soon, we'll know whether we're are right or you're right." The "we" being hard money advocates like Paul.


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This author believes that hard money advocates will be proven "right." In a few years, gold is going to return to the monetary system. That will not be the end of the economic world, but, rather, a new beginning. The "United States Note" dollar was a form of American paper money that was printed from 1862 to 1971, and it will reappear. This time it will be backed by gold or silver, for it is only with a fixed standard that the power of Mandarins and manipulators can be curbed. Only when the US dollar becomes an honest store of value will Americans see a true and lasting recovery. Until then, instability and manipulations will rule the roost. But, eventually, thoroughly discredited debt money, such as the "Federal Reserve Note" dollar and corrupted cousins, like the Euro, will go the way of the dodo bird, never to return.


Markets Insight

March 14, 2012 11:58 am

Stock market rally is running on empty


It’s difficult not to notice that, yet again, there is little substance or confirmation to this equity market rally, despite the fact that it still seems to have some legs.


Yes, there are economic indicators, in the US in particular, that are signalling improvement, most notably the latest employment numbers. On the surface at least, these suggest things may be starting to go in the right direction. The issue of non-existent wage growth still remains, which may explain why consumer spending has lagged well behind this apparent huge improvement in the headline employment data.

 

That Portugal and other eurozone countries apart from Greece have not formally had a “credit event”, and that China has not careened south, are also pieces of good news.



The reality, however, is that the world has not suddenly beenfixed” – not by the Federal Reserve’squantitative easing (QE)”, not by the European Central Bank’s longer-term refinancing operations, and certainly not by ultra-low interest rates across the developed world.



While I have maintained my caution regarding the market and macro outlook, there is never a time for dogma in this business. It is all about generating investment ideas and risk-adjusted returns. We are still in a meat grinder of a market. If not racked by volatility, as was the case in 2010 and again in 2011, then by eerily calm low-volume rallies in 2012.


Sure, two things have occurred recently to cause the “fair-valueestimate of, say, the S&P 500 to rise over time. One is the fact that corporate earnings have more than doubled off the 2009 depressed lows.


This is truly an incredible run-up over such a short time frame (helped in no small part by accounting changes, lower debt service charges, a weaker US dollar and tax benefits).


The other has been the compression in corporate bond spreads, which has fed right into an expansion in the price/earnings multiple. So while the fair-value range was 900 to 1,100 in 2010, and then 1,100 to 1,300 in 2011, it is now in a 1,200 to 1,400 band for 2012.


So yes, the fair-value line has been trending up, but the broader market is now close to bumping up against the ceiling.


And there are opportunities out there. We re-ran our S&P 500 sector screens based on dividend yield and growth characteristics, valuation and earnings-per-share growth estimates and found that the leaders of the pack at the start of the year are still in the lead now: technology, healthcare and financials.


We also found that tech and financials screen well when their price/earnings ratio is benchmarked against growth estimates for the next three years, a measure known as a PEG ratio. From Canada, the sectors we identified with the most compelling PEG ratios are materials, energy, telecoms and healthcare.


That said, it remains clear that this almost-uninterrupted equity market rally lacks substance and conviction.


The rally’s volume has been very weak and institutional players have been absent from the market. There has been very little participation from the retail investor, based on data from Lipper, a provider of information and ratings on mutual funds.
Indeed, US equity-based mutual funds have experienced 10 months of net outflows and $5.4bn so far in 2012. There has not been a year of net inflows since 2005 as private clients have used interim rallies as opportunities to lighten up at better levels.



Corporate insiders have been huge sellers of their own stock, exceeding $6bn last month (with the ratio of selling to buying hitting the astronomical 13-to-1 mark).


Moreover, the constructive price action in the bond pits suggests that asset allocators have been quiet too. The initial public offering market was in a slump during the October-February rally, yet another non-confirm. And merger and acquisition activity has sunk to 2008 levels. This is far from being consistent with a bull market that has any legs to it.


There remains a huge amount to be cautious about out there.


The recent market gains have been all about the more than €1tn injected into the European financial system. The optimism this has engendered is not unlike the brief spurts of liquidity-induced optimism that have followed various rounds of QE in the US.


And many of the economic numbers that have been hitting the tape in recent months have been a reflection of the warmest North American winter on record in the past 50 years, affecting home sales, retail sales, manufacturing and transportation and even consumer confidence.


So this stock market rally does not, in fact, reflect a dramatically strengthening US economy. There is actually a wide divergence between the intoxicating rise of the stock market in recent months and the sobering reality of a tapped-out consumer and fading growth expectations.

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David Rosenberg is chief economist and strategist of Gluskin Sheff

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Copyright The Financial Times Limited 2012.


Democratic Inequality

Raghuram Rajan

2012-03-14.

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CHICAGO – Why did the household savings rate in the United States plummet before the Great Recession? Two of my colleagues at the University of Chicago, Marianne Bertrand and Adair Morse, offer an intriguing answer: growing income inequality.



Bertrand and Morse find that in the years before the crisis, in areas (usually states) where consumption was high among households in the top fifth of the income distribution, household consumption was high at lower income levels as well. After ruling out a number of possible explanations, they concluded that poorer households imitated the consumption patterns of richer households in their area.





Consistent with the idea that households at lower income levels were “keeping up with the Vanderbilts,” the non-rich (but not the really poor) living near high-spending wealthy consumers tended to spend much more on items that richer households usually consumed, such as jewelry, beauty and fitness, and domestic services. Indeed, many borrowed to finance their spending, with the result that the proportion of poorer households in financial distress or filing for bankruptcy was significantly higher in areas where the rich earned (and spent) more. Were it not for such imitative consumption, non-rich households would have saved, on average, more than $800 annually in recent years.




This is one of the first detailed studies of the adverse effects of income inequality that I have seen. It goes beyond the headline-grabbing1%debate to show that even the everyday inequality that most Americans face – between the incomes of, say, typical readers of this commentary and the rest – has deep pernicious effects.



Equally interesting is the link that the study finds between income inequality and pre-crisis economic policy. Republican Congressmen from districts with higher levels of income inequality were more likely to vote for legislation to expand housing credit to the poor in the years before the crisis (almost all Democrats voted for such legislation, making it hard to distinguish their motives). And the effect of spending by the rich on non-rich households’ spending was higher in areas where house prices could move more, suggesting that housing credit and the ability to borrow against rising home equity may have supported over-consumption by the non-rich.



I was most fascinated, though, by the difference in legislators’ response to inequality now and in the past. In a study of the congressional vote on the McFadden Act of 1927, which sought to boost competition in lending, Rodney Ramcharan of the US Federal Reserve and I found that legislators from districts with a highly unequal distribution of land holdingsfarming was the primary source of income in many districts thentended to vote against the act. More inequality led legislators, at least in that case, to prefer less competition and less expansion in lending. And we found that counties with less bank competition experienced a milder farmland boom, and therefore a smaller bust in the years before the Great Depression.



The obvious lesson to be drawn from these episodes is the importance of unintended consequences. In the early twentieth century, a congressional district’s rich landowners were likely to own the local banks as well, or to be related to, or friends with, bank owners. They benefited from limiting competition and controlling access to finance.



Representatives voted on behalf of their districts’ powerful interests. They preferred less competition in credit markets not out of concern for the unwitting farmers, but in order to defend powerful lenders’ profits. It worked, but an unintended collateral effect was to protect these districts from getting carried away by the financial frenzy.



Why did twenty-first-century legislators behave differently? The cynical, and increasingly popular, view is that they were again voting their pocketbooksall financial legislation in the run-up to the 2008 crisis was supposedly driven by the financial sector’s appetite for more customers to devour with teaser loans and dubious mortgages.



But, if voting was influenced by the financial sector, the supposed party of the plutocrats, the Republicans, should have voted in unison for the bill. Instead, they split on the basis of whose non-rich constituents were more desirous of obtaining finance. Twenty-first-century legislators seemed to be more democratic, responding to their voters’ possibly misguided wishes, rather than primarily to powerful financial interests.



Indeed, once the unintended consequences of their actionsmore financial duress for the non-rich after the crisisbecame clear, Bertrand and Morse show that the legislators in unequal districts moved against the financial sector to protect their constituents, voting to set limits on interest rates charged by “paydaylenders (who lend to over-indebted lower-income borrowers at very high interest rates). Of course, such legislation will have unanticipated consequences, which future studies will unearth, but the intent behind it cannot be doubted.



We should not come away from these episodes thinking that expanding access to finance is bad. In general, expanding access is beneficial (just not before a crisis!), but finance is a powerful tool that has to be used sensibly. Access is good; excess is bad.



But there is a more important point: while there are many gaps between the intent and consequences of legislation, legislators do seem ultimately to care more about their less-moneyed constituents than they did in the past. Democracy is stronger. In these cynical times, that is encouraging.



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Raghuram Rajan, a former chief economist of the IMF, is Professor of Finance at the University of Chicago's Booth School of Business and the author of Fault Lines: How Hidden Fractures Still Threaten the World Economy.

.Copyright: Project Syndicate, 2012.