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.”
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.