Euro Zone Austerity is Correct

US and UK economists are quite vehement in opposing the Eurozone’s stress on austerity. They say that this would jeopardize economic growth, which is important for increasing employment and maintaining welfare. But they are just expressing conclusions which stem from the dominant Keynesian view of economics. We will see that this view needs to be amended or replaced.

Addicted to Growth
American economists are addicted to growth. Keynesian economics teaches that governments should use fiscal and monetary policy to maintain growth at all times. Now, at its extreme, the US Fed is the one mainly holding up the US economy by using monetary policy alone. This obsession with growth has led to the Fed and the Bank of England (BoE) to print money (aka ‘quantitative easing’) in order to stimulate growth. People in these two countries have been led to believe that this is a good thing. That the economy will be alright, if only people continued shopping.

Non-economists may find such a policy of ‘printing money and encouraging shopping’ problematic; but then they would be faced by Keynesian economists assuring them that it is right. What the Keynesians fail to realize is that the world  is in the middle of an international tug-of-war for resources. Printing money and shopping are, in effect, asserting the US’ position as ‘consumer of last resort’ at a time when other countries would rather use resources elsewhere. And that is the weakness of the policy: third world booming economies are  increasingly reluctant to prop up the US economy if this means that they would be deprived of resources they need for their own development. The US economy, instead of benefiting the world with its consumption, is more becoming an impediment to growth of other countries.

In this light, the Euro countries’ call for governments to live within their means is a good policy. This means, concretely, that governments should no longer stimulate their economies through excessive government spending (fiscal policy). And combined with the EU’s thrust to lessen its carbon dioxide emissions; it means that Europe’s resource footprint will grow slowly, if at all. It will also mean that Europe will be producing goods and services in an increasingly efficient and competitive manner.

Building Efficient Economies
Government austerity forces economies to be more efficient, and to utilize all their resources properly. Austerity could mean cutting hidden subsidies on fossil fuel, taxes on waste, more efficient production or promoting recycling. While a natural problem with austerity programs is that they may also reduce vital services like the social safety net or public transportation, this will be corrected in the course of the political process as other parties would restore these.

Efficiency includes the concept of a good social safety net, because when workers who are displaced by rapid market changes are well taken cared of, they would more readily accept those changes. Societies should avoid, most of all, the destruction of human capital in the form of forced idleness and de-skilling.

There are also specific policies which skew a particular country’s utilization of resources. Among these are: differences in retirement age (e.g. Greece used to allow retirement at 52 years); low corporate tax (Ireland); or, tax-exemption for mortgage interest payments (Netherlands). Different rules for the Value Added Tax, for social security contributions and benefits; rules for buying and building houses; and, specific taxes on oil, ‘sin’ products etc distort economic and fiscal balances between countries.

Bank of Last Resort?
The idea that the ECB should step in and buy hoards of Italian bonds is wrong. The problem of Italy is that the ‘market’ thinks that its bonds are risky, and thus asks for a higher interest rates for them. While this perception is particularly problematic now, but if the problem does not get out of hand in the medium term, it will eventually solve itself. Investors would eventually settle on buying Italian bonds that have only slightly higher interest rates than German Bunds.

Higher interest rates are important for keeping governments more disciplined when it comes to making their budgets. Making interest rates uniform now (by instituting ‘Eurobonds’ for example) would effectively reward those countries who are misbehaving.

Time is on the side of the EU and the Euro. The Eurozone has a trade and payments surplus. This is quite different from the US, which has budget, trade and payments deficits.  Eventually bond buyers will need to park their money somewhere, and where better than the EFSF and the ESM (which are less than 1 trillion Euros in total, and are as solid as German Bunds)? It will eventually turn out not to be a good idea to park their billions of (petro)dollars in US Treasuries – whose supply increases by at least $1.6 trillion/year.

No Theory Yet
This is not to say that the Eurozone leaders are following a coherent plan, based on a well thought-out theory. Euro leaders are mostly improvising on the run, after being pushed by market conditions to take certain steps; while at the same time also hindered by those same forces from solving the problems quickly.

Economists heckle the policy of austerity because of the Keynesian prediction of an economic downturn if governments cut spending. But austerity is a move that is forced on countries by the market – the market is in effect demanding lower budget deficits, and will punish any government that now does deficit spending. But saying that governments are forced to undertake austerity does not mean that austerity is bad either. Governments are now implementing austerity , which it never would have done without market pressures.

The EU’s decreasing carbon footprint is an independent development, but one which fits neatly into the new EU economic ‘model’. So are the social welfare systems in EU countries, which are only marginally affected by the crisis. Now, the EU is confronted with the need for austerity, together with lessening its carbon footprint and maintaining its social welfare systems.

The present high pressure atmosphere within the Euro zone is clearing out many economic cobwebs. Technocratic governments in Italy and Greece will now work within the parameters, and try to both economize and grow. This means among others: that corruption be lessened, tax compliance improved, and protected professions opened to competition.

A new economic theory will eventually emerge that will affirm the correctness of austerity and reducing the resource footprint under conditions of resource scarcity.

Is US Dollar About to Fall?

The US Congress will have to raise the Debt Ceiling from the present $14.3 trillion by August 2, or else the country would face technical default. But the Republicans are demanding budget cuts be done first; and Democrats are demanding that measures should include increased taxes for corporations and the rich. Both sides are standing their ground, and there is a real danger that the country will indeed default by August 2.

Most probably, a deal will be made at the last minute, and the US can go on merrily increasing its national debt for a few more years. But the question remains: can the US dollar’s credibility withstand such a strain? Will the US dollar fall while Congress debates over raising the Debt Ceiling?

I think that sooner or later, within the next 5 years or so, the US dollar is going to “fall”.  The national debt limit is only part of the problem; the main problem is that the US has a triple deficit – of the budget, trade balance, and payments. And that it has accumulated a huge amount of “unbacked liabilities” in the world – to the staggering amount of $75 trillion.

All proposals on the table will help to reduce the budget deficit, but it will even not be enough to get a balanced budget.  Since there will continue to be a deficit in the coming years, the national debt will continue to grow. And then, there is the trade deficit which also grows from year to year. Thus, all plans now being considered will not improve the US’ capacity to repay its debt.

The world is getting impatient with the dollar, and it seems that US politicians are taking their time at solving it, not realizing that the problem is really urgent.

Signs of Trouble
The problems in the Middle East are all in the news. But the biggest problem with it lies not in Libya or even Yemen – but in the fact that the US dollar has not strengthened in the face of all these problems. Almost always before, when there is political turmoil somewhere, the US dollar gains in value, as money exits that country and goes to the safety of the US dollar. Now, the whole Middle East is ablaze, and the dollar, instead of strengthening, has weakened considerably.

Another sign of impending trouble is that the US, even with “QE2” (the program of the Fed for creating $ 600 B by buying government treasuries) and the extremely low Fed interest rate, faces rising commercial interest rates. QE2 was instituted in the first place to REDUCE interest rates. What will happen after June, when the QE2 program is over? Will interest rates rise substantially, resulting in a rise in unemployment? Will there be a double dip recession? If the Fed makes a “QE3” program instead, will this be enough to hold interest rates down? or will foreign fund managers dump US treasuries instead?

A third sign of trouble is the news that PIMCO, the world’s biggest holder of bonds, has entirely stepped out of US Treasuries. Even worse, PIMCO has resorted to selling US Treasuries short – which means that it even has negative ownership of Treasuries. This shows that US Treasuries are no longer attractive to the wiser international investors. I doubt that many hedge funds keep Treasuries in their portfolios either.

A fourth sign is that when Osama bin Laden was killed, he had with him 500 Euros. He had Euros, not US Dollars, which means that he considered Euros more useful in case he had to escape capture in Pakistan – Euros seem to be more useful in bribes etc. in Pakistan. This shows that even in the underworld, the US dollar is not considered a good currency anymore.

Roots of Crisis
The present crisis has its roots way back in the Bretton Woods agreement, made after the Second World War, to have the US dollar as the world’s reserve currency. Until 1971 the dollar’s value was pegged to the US supply of gold, keeping the US currency in “control”. In 1971 President Nixon let loose the gold peg, making the dollar itself as the only thing in reserve.

The US dollar as reserve currency meant that countries were willing to run a trade and exchange imbalance with the US, since this would mean that they would accumulate US dollars in their reserves. This meant that the US tended to have a structural trade and payments deficit with the rest of the world. This  effectively overvalued the dollar, making its imports cheaper than they otherwise should be. And this contributed to the very high standard of living in the US.

Over the decades, the US steadily accumulated a big debt burden. It is now at $14 trillion, or more than 90% of the US’ annual GDP. Among developed countries, it is only Greece and Japan which have higher debt/GDP ratios. Greece has had its debt crisis, and is now forced to undergo a strict program to get rid of its deficit. As for Japan, most of its debt is to Japanese citizens – and thus the impact of the debt is less than if it was held by foreigners.

The US debt is only part of the “US dollar overhang” in the world economic system; because the bigger part (approximately $60 trillion)  is simply the dollar reserves that countries have accumulated, due to the US trade deficit.  The national debt, in the form of US Treasury Bills, is the smaller part of the problem; but it is the more worrisome part of it, since the US has to pay interest on this.

Stumbling into Dollar Fall
The danger is always present that a country would decide to dump their US treasuries, leading to a chain reaction that sees other countries dumping treasuries, a spectacular rise in interest rates, and the dumping of US dollars from national reserves, and the fall of the dollar. This has not happened so far, since no country will do that consciously and devalue their own reserves. But we cannot depend on this not happening in the future. In fact, I think that the chance of this happening is getting bigger with time.

As more and more dollars are sent abroad, in the form of  US Treasury bills or simply “cash”, the danger that they will no longer be accepted by other countries increases. Already, many countries are calling for an overhaul of the international currency system. Countries have to continuously weigh the advantages of holding dollars against the cost due to the continued watering down of the dollar’s value.

Even if no country would willingly cause the dollar to fall by dumping it, a series of smaller events could push things so that even  minor players could accidentally cause such a fall.  The recent intervention against the Japanese Yen had the inadvertent effect of increasing Central Banks’ reserves of dollars. Central Banks all over the world had to subsequently find ways of restoring their dollar reserves to normal levels. The BRICS agreement to use their own currencies when trading with each other means that less dollars need to be kept as reserves. Eurozone countries intervention to support weaker Euro countries’ finances is another measure that strengthens the euro against a potential fall of the dollar. All these make the dollar weaker. A disruption of the scale of the 2007 sub-prime crisis happening now would surely topple the dollar.

Perhaps it won’t even be a single country or investor which would precipitate the dollar’s fall. It could be simply an accumulation of small steps that would push it over the edge. The US high unemployment rate has “forced” the Fed to keep the Fed Funds rate low, but this at the same time increases consumption and imports, and to further trade deficits.

The US dollar is undergoing something like a game of international “musical chairs”. US-based investors buy securities in other countries, effectively moving dollars abroad; Central Banks sell dollars to prevent their currencies from appreciating; the continuing US budget deficit means that the government has to issue more Treasuries;  foreigners buying US equities or Treasuries effectively returns dollars to the US;  too much incoming dollars could cause inflation, and increase unemployment. The cycle continues, and dollars are passed back and forth from the US and abroad.  A growing number of Central Banks are wary of keeping too much dollars, and this cycle would eventually break down at some point.

Tipping Points
There are a number of occasions or events which could push the dollar over the edge. The Debt Ceiling of the US has been reached, and by August 2 the US Congress has to agree to raise the limit. Not to do so will surely bring about a loss of trust in the dollar, and its subsequent fall.

And then will come the budget discussions later in the year. This is another occasion when confidence in the dollar may be critically damaged.  This will be followed by the Presidential election campaign and possibly a new administration.

At any time, Congress may pass a law imposing a tax on Chinese imports. This will cause Chinese countermeasures, including a stop to buying US Treasuries. And this will be enough to precipitate a chain reaction that will cause the fall of the US dollar.

The US dollar will fall within the next 5 years. While it will cause a deep crisis, it won’t be that bad, in the long run. I wrote a blog post about how it will be Two Years After the Dollar Fall

Two Years After the Fall

It is now March 13, 2014. America has undergone a huge shift in its economy in the last two years. On this day, in 2012, the dollar “fell” in value, by about 100%; and more importantly, it “fell” from its position as the world’s reserve economy.

The Dollar Falls
It all started in November 2011. Riots had broken out in Saudi Arabia, and the government was frantically trying to restore order. The Saudi government had bungled in its handling of a relatively small disturbance among Saudi Shiites in Qatif, in the Eastern province. In November 2011, the disturbance had escalated into a nationwide protest movement. By December, workers in the vital oil industry and in the ports had gone on strike. And the demands had hardened – where before they had merely asked for the release of arrested Shiite leaders, protesters had now gone on to demanding a Constitutional Monarchy, some even wanted a republic, while others were calling for the independence of the Eastern province. All of this caused the price of oil to go through the roof. By the end of December,  oil had reached $200/barrel.

To make matters worse, the US response to it was also wrong. Congress passed a new Stimulus Bill of $500 billion, and the Fed proclaimed QE4 – a program to pump $1 trillion into the economy, as a response to the new recession. Unlike what happened during the 2008 recession, however, the US was now alone in pursuing an expansionary policy. This caused a lot of misgivings in other countries regarding the value of the US dollar.

Oil producing countries responded by demanding that they be paid in “hard” currencies – e.g. Euro, Yen, even the Chinese Yuan – and NOT in US Dollars. By January 2012, Central Banks all over the world decided to cut the US dollar component of their reserves, by a modest 1/4. Thus, from an average of 80% of reserves in US dollars, to 60%. This seems to be a modest change in policy; but when it is done by ALL Central Banks at the same time, it had a devastating effect. This policy meant that the Central Banks would gradually replace their dollars with other currencies in the course of a number of months, eventually ending with the target percentage of US dollars in reserve. By the end of February, however, the value of the US Dollar had gone down to the point where Central Banks holding lots of dollars (mostly in the form of US Treasury Notes) became nervous. They stood to lose a lot, if the dollar lost value.

So, it finally came on Tuesday, March 13, 2012. The Saudis were the first to dump their US dollar holdings. This was followed by Russia, Japan, and then China. After this, everybody else dumped their dollar holdings. You could probably speak of an “oversold” situation with the dollar then, but Central Bankers didn’t care anymore – they just wanted out, as quickly as possible.  As a result of all this, the dollar sunk to $4: 1 Euro on March 16, 2012. In the months following, the dollar regained some strength, finally stabilizing at $3:1Euro by December 2012.

Picking up the Pieces
The US was left to pick up the pieces. It still had a big budget deficit, and a huge payments deficit, and a 16 trillion national debt. The only good news in all this was that the national debt remained at 16 trillion dollars, even though the dollar was half its former value (thus, effectively the national debt was reduced by half).

The US had to go to the IMF to borrow money to finance its budget deficit. Nobody else was willing to lend the US money at that time. The US got a 500 billion SDR loan from the IMF (roughly equivalent to $500 billion at the old exchange rate). But the IMF loan came at a price: the US government had to cut spending, and increase taxes, and it had to have a concrete program to balance the budget by 2015. The US also had to open up its economy to foreign investments (thus, the airline, oil, banking etc. industries were opened to 100% foreign ownership).

Recovery
The IMF conditions were tough, but now, 2 years after the fall, the economy is on its way to recovery. US labor costs had dropped in relation to the rest of the world (while the US dollar’s value was halved, prices rose 30% and wages rose only 10%). This has led to a huge expansion in US-based manufacturing of products which used to be imported from China. (Another large chunk of the production had gone to Mexico, from which it is cheaper to ship to the US.) Automobile production has greatly expanded, with so many people buying smaller cars, hybrids and EVs (Electric Vehicles). And there is now a huge demand for buses, as local governments expand their public transportation services.

Tourism is now booming, with Asians and Europeans making the most of  “cheap” US vacations – tourism revenues have quadrupled since 2012. There is also a surge of “medical tourism”, with Europeans and Asians coming for elective surgery (which are not covered by their country’s health insurance).

American university enrollment has surged; while the number of American students has lessened, foreign students have more than made up the loss. Foreigners find that the US is offering quality education at bargain prices. And while foreign graduates are now in demand in the US, a bigger percentage of them opt to work in their home countries about graduation.

The stock market is enjoying a bull market of sorts – the Dow Jones just topped 20,000 points last January. Some companies are having a hard time: Walmart’s sales suffered as a result both of the lower purchasing capacity of people and the higher prices of goods. It is now repositioning stores to city centers, since people now find their suburban locations “too far away” (due to high gasoline costs). Starbucks has suffered because people have decided en masse that Starbuck’s coffee is a “luxury that they could live without”. Airlines are suffering from people cutting back on air travel.

But more companies are thriving: McDonalds has noted an increase in sales, even in the face of 30% higher prices; Amazon has seen a boom in the sale of Kindles and e-books (paper prices have also spiked); IT companies are profiting from people spending more time at home (people are also working more from home).

People have developed new habits. The magnetron is still all important; what’s new is that companies are now selling magnetron meals in reusable containers. Children often go to school now on bikes (leading to a reduction in child obesity). People are consuming more (local) vegetables, and eating less meat.

Many more people are employed than at any time in the past few decades. The unemployment rate is now at 5%, and is still dropping. There are less illegal Latinos now, since many Mexicans now prefer to work in the new Mexican factories. Americans are now more willing to take on farm jobs that were formerly done by Latino migrants. There is a marked reduction in the drug trade, with lower US buying power and prosperous Mexican workers.

There are now plans to build a nationwide rapid rail network. Ordinary rail lines are more intensively used for carrying products (replacing trucks), and a lot more products are transported by water. Solar farms are being set up in the Southwest; in Hawaii, the government is feverishly building solar and wind power plants (Hawaii was the worst hit by the oil price rise).

The “fall” of the dollar has caused a lot of suffering in America. But the American people are not only adapting well to the change, they are actually thriving. The resilience and hard work of the American people is now showing that a new economy could be fairer, greener, more equal, and eventually, more prosperous.

Some people say that the “fall” may have been the best thing to happen to America. They’re probably right. The future indeed looks quite bright.

$1.45: 1 Euro by the end of 2011

The year 2011 will be marked by a very significant deterioration in the dollar exchange rate. I think that the exchange rate by this time next year will indeed be $1.45: 1 . Why do I think so?

Why?
Well, the most obvious reason is that the US is printing too much money, accumulating too high budget and trade deficits, and borrowing too much. The US Fed is stimulating the US economy as if it was the only economy in the world. They don’t see the international effects of US economic policies. Well, I think that 2011 will show that there is a limit to the amount of US dollars the world can take. At a certain point, people from other countries will have to be convinced by high interest rates to invest in US treasuries. And this would mean a devaluation of the dollar.

Even without “Quantitative Easing 2” and the extension of the Bush tax breaks, I think the US dollar will be in trouble anyway. At the beginning of the year, Central Bankers (Central Bankers are very “neat” in that they make policies that start at the beginning of the year, or half year, or quarter) will most likely set their policy regarding the amount of US dollars they will keep in reserve for the coming year. And I think that they will set the target percentage for dollars at either the same or at a lower level than that for 2010.  The dollar is a declining component in world trade, and it is also expected to devalue, so prudent Central Bankers will aim to have a lower percentage of dollars in their reserves. This, together with the rise in the amount of dollars that go around the world’s financial system, would mean that there will be a growing amount of dollars that are dumped by all these Central Banks. All these extra dollars means that the US dollar will devalue.

What about the Euro and its crisis? Well, to make the long story short: the Euro crisis is over. 2011 will be the time of the dollar crisis; and as a result, the problems of the Euro will be overlooked or actually get solved. Investors are sure to notice that the US economy is heavily indebted, and that the dollar is devaluating; so, they will think twice before buying US treasuries. After all, the US economy is worse off that either the Portuguese or Spanish economies. People will see that, and will eventually have to act accordingly.
This will bring about a domino effect: lower demand for treasuries; speculators betting (through Credit Default Swaps e.g.)that the interest on treasuries will rise; interest on treasuries actually rising as a result, etc. If speculators get the idea of dumping their other US dollar denominated assets, then devaluation will surely result.

The US can still stop this trend of a devaluating dollar. However, I think it won’t, and for the simple reason that they want the dollar to devalue. US economists seem to think that this is a good idea – that devaluation will stimulate exports and lessen imports. So, the Fed will not do anything to defend the dollar; and thus the dollar will devalue in 2011.

Is Devaluation a Good Idea?
For a small economy, it indeed could be a good idea to devalue its currency in order to restore its balance of trade. Devaluation will make that country’s exports cheaper and make imports more expensive, forcing the market to restore the trade balance after a while.

For the US dollar, however, it will be a bad thing if it devaluates. And this is because it is the world’s main reserve currency. Devaluation will not only lower the price of the US’ exports, it will also lower the value of reserves other countries have built up. For many countries, holding US dollars becomes a game of chicken: they would keep it as long as possible, but dump it before everybody else does. But when the Central Banks start dumping dollars, there will be no stopping the trend.

So, devaluation will not only affect the trade balance. It will affect how other countries view the dollar. And this means that if they sense a trend of devaluation, they will  dump their dollars in the hope of preserving the value of their reserves.

Devaluation will also be bad for the US itself. When the dollar loses value, the amount of imports will take 6 months or longer before it starts going down. This means that oil and other commodities will sap the US trade balance for some time before going down.  And it will take some time before exports get a boost. There is a lag time before companies are able to increase production accordingly.  And there is China: if present trends continue, China’s yuan will maintain its value rate relative to the dollar. This means that imports from China will not be affected, and exports to China will also not increase.

Devaluation will mean that people will pay a higher price for oil. I would estimate it to reach $4/gallon in 2011, at least. Other commodities will also rise in price: from iron ore to rubber, copper, aluminum. And this will cause the price of goods produced in the US to rise accordingly.
Devaluation means that consumer prices in the US will rise. It may not rise by the same percentage as the devaluation, due to importers absorbing part of the loses, but it will surely rise.

Devaluation of the US dollar, if it goes beyond a point, would mean that other countries would consider dropping the dollar as the currency used to price certain commodities. Take for instance oil – it is still denominated in dollars. But if the dollar devalues too much, OPEC may just decide to drop the dollar/barrel measurement, and revert to perhaps a Euro to metric ton pricing.

It could be worse
That the dollar will devaluate, is practically a given. But a depreciation of 10% is not the worst possible case. It could indeed be worse. Here are some things that could make the scenario even worse for the dollar.

Germany Agrees to ECB Issuing Euro Bonds. So far, the Germans are holding back on this, for the reason that it pays much lower interest rates with the present system of each country issuing its own bonds. However, if for whatever reason, the Germans (and other “Northern” countries, e.g. the Netherlands) agree to let the ECB issue common bonds for the whole of the Euro zone – which would then have an “average” interest rate; then it will forever get rid of any reason for a Euro crisis. And this would mean that international investors will more enthusiastically tear down the price of US treasuries.

China Shifts Its Peg to a “Basket of Currencies”. If China lets go of its dollar peg, it will not be good for the US. It’s funny – the US has been insisting for years that the Chinese should revalue its currency. But if China does so, even if only a little, it will mean a lot of trouble for the dollar. Changing the peg for the yuan will mean almost certainly that China will stop buying US treasuries. This means that the price of treasuries will drop, and effective interest rates on them will rise.  And China’s dumping of US treasuries will be sure to trigger similar actions by other countries.

Big Disruption in the Supply of Oil. The price of oil is now at about $90/barrel.  It will slowly rise to about $100/barrel by the end of the year, given present supplies.  If there were to be a major disruption in the supply of oil – perhaps a total stop of Nigerian or Venezuelan exports – the price will rise to even $150/barrel.  While the world has seen these price before, it is now less able to cope with it. So, a big rise in the price of oil will be greeted by a return to recession for the US, and a big drop in the value of the dollar.  The dollar will lose more than 10% of its value, as a result of this.

I don’t think that these “worse case” scenarios will happen in 2011 (well, 2012 is another story altogether). So, this means that the US dollar will devalue by “just” 10%.

Unfortunately, I think that this trend is inevitable. The dollar will devalue by about 10% in 2011. It may devalue by the same amount in 2012. And if this continues, the dollar will cease to be the main reserve currency soon after. Only the Fed can stop this. But it won’t. It is not politically expedient for the Fed to do so.

QE2: A Formula for Disaster

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.