‘Quantitative Easing’ sounds better than ‘printing money’: more like a low-pain diet plan. How much economic nutrition does it provide? In abbreviated form like ‘QE2’, it sounds like an ocean liner for those old enough to remember. Has America booked a cruise for inflationary shores?
Upon the June 30 termination of Quantitative Easing Phase II, U.S. Federal Reserve chairman Ben Bernacke indicated there will be no Phase III in the near future. He did so again in his much-watched August 26 speech at an important annual gathering of big-wigs in Jackson Hole, Wyoming. The overall economy still looks quite shaky, so what’s the hold up, Ben?
Pioneered a decade ago in Japan as an economic stimulator, QE came to Europe and the U.S. in 2008. The U.S. program has been by far the largest. For conventional monetary stimulus, the Federal Reserve has two means of trying to push general interest rates down so that firms will borrow and produce while households borrow and buy.
It can reduce the interest it charges to banks with overnight borrowing needs, thereby allowing those banks to reduce the interest they in turn charge on loans, while still maintaining a spread. The Fed can also increase the active money supply by dishing out dollars for ‘open market’ purchases of short-term government debt or foreign currencies. With money more available in the marketplace, lenders must reduce the interest they charge from borrowers.
QE comes in when you want monetary stimulus, but interest rates are already near rock-bottom. Normal tools cannot work to bring interest rates down. QE resembles open market purchases, except that the Fed buys assets it normally avoids, including long-term government debt, corporate bonds, asset-backed securities or even equities. The U.S. QE2 that ran from November 2010 to June of this year focused on massive purchases of U.S. Treasury bonds.
How did this take place?
The Fed first waves its wand, crediting its own account with new money and then transfers those credits to banks from which it acquires the T-bonds. The hope is that the banks will then lend this magic money out into the broader economy at low, low rates. Interest rates, according to theory, will move downward because more money is circulating and also because massive purchases push T-bond prices up. (To grasp this latter point, my fellow Econ 101 flunkies should try to recall two key lessons. First as a bond’s resale price goes up, its ‘yield’ or the difference between its price and its face-value pay-out at maturity goes down. If I pay 80 cents for a bond worth one dollar at maturity, my yield is 20 cents, (25% of 80), but if I pay 90, my yield is only 10 (11% of 90).
Second, as government bond yields go down, general interest rates follow. A lender’s bargaining leverage is the threat of buying safe-yield government bonds (lending to the government) instead of making loans to other potential borrowers if those borrowers won’t cough up more interest than the bond yield. As bond yields fall, lenders’ credible ‘exit threat’ point declines correspondingly and general interest rates trend downwards).
Skeptics of U.S. QE have from the outset pointed out that the huge increase in circulating dollars could touch off inflation and would tend to push the dollar downward against other currencies. Holders of U.S. government debt--how do you say ‘depreciating asset’ in Chinese?--gulped hard at the prospect that America might pay off its gigantic debts with massively devalued dollars. Meanwhile, countries that live by export--Brazil, Japan and Germany, to name some big ones, not to mention China--saw QE as a sneaky way to push the dollar down and muscle in on their market shares. Aside from these predicted side effects--or were they the real purpose?--skeptics predicted that QE would fail to revive the U.S. economy.
How have things worked out for everyone then?
Consensus has it that QE1, which ran to the tune of $1 trillion between late 2008 and June 2010, ameliorated the financial sector emergency by loosening credit to U.S. firms and households. Reduced mortgage rates left Americans with more change in their pockets. QE2- $600 billion between November of last year and June of this--had the more ambitious objective of stoking U.S. recovery. In this it has proved disappointing: growth rates are down so far this year and unemployment is up. Long-term interest rates have come down only slightly, perhaps because inflation-fearing holders of government debt sold heavily while the Fed was buying.
On the apparently cheerier side, the dollar flood pushed nominal stock prices up a joyous 25% as of the termination of QE2. (Stocks have fluctuated and fallen somewhat since then, due to continued high joblessness and the flapdoodle in Congress over raising the debt ceiling.) Pumping up the stock market was probably a secondary purpose for QE2: equity owners would perhaps feel a resulting ‘wealth effect’ and step up consumer purchasing while firms would bring in more investable cash from fresh stock offerings.
If QE2 did indeed boost stock prices, two caveats must nevertheless be noted. First, 80% of American households own little or no stock. Second, upward motion for stocks should perhaps be viewed against the dollar’s downward drift. The dollar’s decline means June markets were up only 2% when measured in Swiss francs. Doh!
More good news is that Wall Street financial houses are showing hefty profits: we can all feel good about that, right? Even there, however, problems lurk. Recent analyses suggest that the big houses are in big trouble, their stocks trading at far below ‘book value’, which means that markets believe the houses are covering up dangers that their outstanding loans will not be repaid. Big-house recipients of QE2 funds have not, as was hoped, stepped up fresh domestic lending. The reasons are not far to seek. American firms are already sitting on large piles of cash, which they are not using for expansion as long as Americans can’t afford to buy more.
Why would they take loans? While firms sit on mountains of cash, households sit on mountains of debt, run up on credit cards and mortgages. They can’t afford to take new loans. Mortgage lending has stalled and housing prices have resumed their depressing stumble.
One bright light is that QE2 did not touch off serious inflation, at least not yet. One recent study suggests that the active U.S. money supply has not actually expanded with QE2: no surprise since potential domestic loan capital currently has nowhere to go. Seeds of inflation may merely be dormant, however, ready to germinate with faster money circulation if recovery manages to pick up speed. It would be dismal to see accelerating recovery chased down by galloping inflation.
Worldwide, several effects of the QE dollar flood appear clear. Commodities from gold to oil were bid up sharply by speculators and inflation-hedgers. Since QE2’s termination, prices have begun dipping a bit, good news for the world’s poor whose food prices had soared with the high cost of oil. The dollar is down as predicted and developing markets have experienced extra upward pressure on their currencies as QE funds drain out of the U.S. to more promising outlets.
This may facilitate useful investment, of course, but may also pump up asset bubbles. Worried about export competitiveness, some developing-market countries have tightened up on capital-flow controls while their central banks have tried to keep the lid on their currencies by selling them for dollars. One critic contends that QE2 in one stroke wiped out fifty years of developing-world progress toward more open capital markets. He’s exaggerating, surely….
The prevailing view is that QE has reached the point of greatly diminished returns and that economic recovery will have to emerge instead either from renewed budget-busting upticks in government spending (Democrats) or from the mysterious bosom of free markets
Right-wing Republican Presidential candidates Ron Paul the congressman and Rick Perry the governor have both garnered media attention from bashing QE. Ron Paul calls the increased inflation threat a ‘hidden tax increase’ on the American people, while Rick Perry came close to calling Bernacke a ‘traitor’ for weakening the dollar. Bernacke is no traitor, of course. The wisdom or folly of QE is a matter of policy differences, not fundamental loyalty. If we put Perry’s incendiary rhetoric aside, however, reservations over QE seem to be prevailing.
Sometimes even kooks from Texas get it right.
Mark Hager is an American lawyer living in Pelawatte. A graduate of Harvard Law School, he consults with organizations as a writer and as a negotiation trainer with Sea-Change Partners.