Carlo's Think Pieces

Reflections of a Filipino in the Netherlands

QE2: A Formula for Disaster

Posted by butalidnl on 1 November 2010

The US Fed will soon decide whether to embark on a program of quantitative easing (QE2), which will mean that it will pump from $500 billion to $2 trillion dollars into the US economy, in the hope of stimulating it. This will be the second time in the recent past that it will do so.  In 2008, the Fed “created” $1.7 trillion, and used this to buy mortgage-bound securities, which nobody wanted to buy, and get the economy moving again. Now, with the economy growing at 2% and with 10% unemployment; the Fed wants to use quantitative easing again, in order to induce the economy to grow faster, and to lower the unemployment rate.

I think this is simply a recipe for disaster. In the first place, the “bubble” which burst in 2007 was caused by excessive spending, especially in the housing market. Now, the Fed wants to address the ensuing low growth by pouring money into the system. It sounds like the saying: “avoid hangover, stay drunk.”

US Centered
The Fed is playing with the idea of quantitative easing (QE2) because, for them, QE2 will stimulate the economy, and there would be minimal bad effects.  But this is because they only look at the short-term situation of the American economy. They do not realize, for one, that QE2 will have a detrimental effect on the US Dollar’s reputation the world over. They assume that the dollar’s prestige and acceptability all over the world will be the same even after QE2.

I think that this all depends. If QE2 is limited to say $500 billion, perhaps it may not have that much of a detrimental effect on the dollar’s prestige (though it is really going to be at the edge, I think). But if QE2 will be $2 trillion, then I am almost sure that there will be a chain reaction in the world that will turn around to bite the US back.

The US Dollar’s prestige throughout the world is declining, and since it is not an “ordinary” currency (but rather the world’s reserve currency) it needs to maintain a minimum of prestige and value for it to continue in its present role. That the dollar will remain as the world’s reserve currency is not a given; and I think that printing too much additional dollars will severely damage the image of the dollar.  And if this image is severely damaged, think of the consequences: what if the Saudi’s suddenly decide to take their currency off its US Dollar peg? What if this would lead to a substantial increase in the dollar price of oil? And what if the Chinese decide to get rid of their own US Dollar peg? These events are not theoretical; I’m sure the concerned governments are seriously thinking about it.

Money created through quantitative easing does not remain in the US. Hedge funds use this to buy fixed-interest assets in other countries, causing those countries’ currencies to rise in relation to the US dollar. And this will force these countries, sooner or later, to raise the dollar price of their exports, just to be able to maintain their profits. This will in turn mean that imported products in the US will cost more.

Even for the US
But even for the US, QE2 at this moment will be quite ineffective to stir the economy, and at worst will even cause more trouble. QE2 will increase the supply of money, but this will not do too much in the way of solving the problems with the housing sector. Increasing the money supply will not save people’s homes from foreclosure; and thus could not solve the problem of low consumer demand. People don’t spend as much because they fear they may lose their jobs or the houses, and I don’t see how pumping money into the economy will help this.

Sure, economic theory says that additional money supply could stimulate the economy, even the housing market. But this is true in a “normal” situation. Additional money, when provided at a time when banks are willing to lend, and when there is sufficient consumer demand (or industries are busy investing and hiring), will mean that the economy will grow faster than it otherwise will. But consumer demand and industrial investment will not happen just because there is money available; consumers and businesses should have at least a minimal level of confidence before they increase their expenses. This is like pulling a horse so that it is next to the river; nothing you could do could compel that horse to drink. If it is thirsty, it will drink. If not, there is no way that you can force it to drink.

But worse than being ineffective, QE2 could also do harm. For one, it creates an oversupply of bonds, which are fixed-interest instruments. This translates to low interest rates, which has a detrimental effect on pension funds and insurance companies. It also creates an artificial boom in the prices of stocks and even commodities.  The artificial boom in stocks will lead eventually to another stock market crash. And the rise in the price of commodities will mean higher consumer prices for the people.

QE2, by increasing the money supply, and through the mechanism of “carry on” trade (where people borrow cheaply in the US, and invest the money in fixed-interest instruments in other countries, taking advantage of the interest deferential, and possible foreign exchange gains) will devalue the US dollar. And this devaluation, some economic theorists say, will increase exports and decrease imports. True, it will. But it takes 18 months for exporters to gear up, and importers to adjust their purchases downwards. In the meantime, the balance of trade will worsen because exports remain the same, while the price of imports rise. And, in this world today, an 18-month gap is a long time; long enough to cause a downward spiral in the economy.

The inflation that the Fed wants to induce will come. The problem is that I don’t see how the Fed will be able to stop it when it comes. I don’t think that inflation will simply stop rising where the Fed wants it to. It will continue rising. And, if it is accompanied by low growth, that inflation will not be easy to eradicate. It will have become stagflation.

If the Fed realizes the full implications of quantitative easing on the US and world economy, I think they would think twice about using this instrument. Then, it will be the case of limited positive effect against a very dire possible negative effect.

The Fed would be well advised NOT to use quantitative easing at this time. Let the US economy grow at 2%. While this is low, it is a good basis for the economy to build on to achieve higher growth rates later. The US economy had been on a spending binge; let it recover gradually.

2 Responses to “QE2: A Formula for Disaster”

  1. Chetano said

    Carlo, your Nov. 1st entry title “Formula for Disaster” is in need of clarification and editing. First, you need to clarify what you are referring to as the “bubble” in 2007 [para. 2] as it’s not apparent at the outset which bubble you are speaking of: is it the housing bubble? (US or global?); credit bubble? Netherlands bubble? Euro bubble? commodities bubble?
    The housing bubble in the U.S. actually popped or had begun to unravel around April 2006 (see http://moneycentral.msn.com/content/P149596.asp) while the US financial/credit bubble which started decades ago came to a screeching halt in late summer 2008. I think you have mischaracterized what caused the bubbles. I would not characterize either of these bubbles merely as results of “overspending” as you put it. From the federal govt to enormous financial firms down to small banks and lenders – it was lax regulators and policies regarding lending/credit, leverage and financial derivatives that caused the bubbles more than anything else. Overspending was the product of the excessive lending and credit issued during a time of frenzied speculation. Overspending did not, by itself, cause the most recent US housing and global financial crises. Again, these bubbles were largely manufactured and induced by Wall Street. The overspending that was done by borrowers and consumers is in no way as culpable as Wall St. for the housing and credit bubbles that have recently burst.

    On the other hand, in today’s post-crash high unemployment environment in the US the problem is that there is too little hiring by corporations and small businesses. Cash flush corporations are uncertain of the future while small businesses’ credit lines have been drastically cut so that across the board hiring suffers, unemployment stays high, and employment/income driven consumer consumption which fuels seventy percent of the economy stays anemic to low. The ongoing implosion of the US housing sector is not as big a threat to the economy as high unemployment and low economic growth. The housing and mortgage problem, with foreclosures on the rise a definite thorn, will continue for several years but this environment, deflation is still a major concern to the Fed.
    Inflationary spirals are hands down without question much easier to deal with and emerge from than deflationary spirals. I don’t think the Fed has or knows of any effective tools to halt or pull the US out of a major deflationary decline. That would be the real disaster or catastrophe and lead to social upheaval that could lead to global conflicts and even armed aggression.

    On Quantitative Easing, to say that the Federal Reserve (Fed) needs to “think twice” before they implement the so called QE2 policy demonstrates either a lack of understanding of Ben Bernanke and the Fed or a poor choice of words. The Fed, with rare exception, moves slowly and measures its moves with rigorous and vigorous debates almost continuously. They certainly realize the risks associated with their easing policies and are well aware of your specific concerns. No doubt there could be a significant price to pay if the dollar’s decline causes currency wars as a result of QE2 – but global currency and trade concerns almost always take a back seat to employment issues – especially if the Fed believes it will not upset the global apple cart too much in the short term and will right itself once the US economy gets on track. The Fed believes the country cannot risk being hobbled by prolonged high unemployment.

    So should the Fed try QE2? Taking as a given that QE2 will weaken the dollar and drive interest rates lower what is a reasonable outcome? If the dollar is weakening and interest rates are falling most prudent and even unsavvy investors would not want to hold onto large amounts of cash and would therefore invest monies into stocks. The effect of this incentive will be a “surge” in investment – not unlike the 2007 troop surge in Iraq that brought relief to the unstable situation there. The wealth effect of rising stock portfolios will induce consumers to open their wallets and create greater demand. The Fed is hoping that this wealth effect will be big enough to remove enough uncertainty from the minds of large corporations that they start hiring again. This of course is a big hope as historically government money creation has largely been ineffectual in spurring on recoverys. However, if the wealth effect from QE2 can create even a one percent rise in employment from current levels within six months that will be a very significant lift for the economy. The Fed believes a more stable US economy will go a long way toward ensuring the global economic recovery stays for a long while. If the US stays at it’s current levels of growth and employment for 4 or 5 years – the long term debt and budget issues of the US will be much more difficult to deal with in five to ten years and raise serious questions of viability about the US economy – which would be the real disaster. In the short term the world cannot afford to lose or have a much weaker US consumer because America is still a source of demand for the world’s products. Bernanke and the Fed will use everything in their arsenal to avoid
    a Japan situation. If they need to do even more rounds of so called quantitative easing – it will. And again, it’s not for lack of having debated and thought thru the process and it’s risks that they will do so. It is the prudent thing to do. And I believe, rightly so, that they will only cut back when they feel they have met the minimum levels of growth necessary to get the US out of harms way – and it’s not at nine percent unemployment. The buying of $600 billion in long term govt bonds by the Fed is not without peril, but it is the best thing we’ve got left in a world of weak choices. The United States is already on a currency collision course with China but that will have to be dealt with at a later date by both countries if not more constructively by China itself today becuz the Fed will not back off it‘s plan.

  2. D said

    This whole printing of money or adding more zero to their record is simply stealing savers of their wealth unknowingly. The Federal Reserve (not Federal at all but a private entity protected by the rules created by lobbyist) is robbing the whole world of its wealth and resources. The whole concept of bonds is but a credit card swipe with the name of the kids of the future/ good faith in the system. It is currency war as US pressures China to speed up the appreciation of RMB causing housing bubble to occur on their side just as what happened in the US. I don’t know how it is going to unfold in the near future as many states here in the US are actually in debt and may actually default soon. We’re on our way to austerity measure just as what Greece is having right now, maybe worst since USD is the currency reserve. Can’t wait to have it audited and see who got the dough.

    Hope no one blocks Ron Paul’s effort and other true patriot on auditing the Fed Reserve. There was a time on 2009 that it almost got audited but then some change their vote.

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