Quantitative easing may lead to disaster
It’s November 2012 and Barack Obama is living out the last few weeks of his one-term presidency. History is being made for a second time: the first black commander in chief replaced by the first female holder of that exalted office after Sarah Palin’s victory.
After his defeat, Obama is asked when it all went wrong. Looking back, he says, the key moment was 3 November 2010, the day after mid-term elections went badly for the Democrats, when the Federal Reserve took the decision to pump an extra $600bn (£370bn) into the US economy by creating new electronic money.
The Fed was warned at the time that what it was doing was high-risk stuff and took no notice when the former Ronald Reagan staffer David Stockman said it was injecting high-grade monetary heroin into the financial system. Instead of accelerating the US economy’s recovery, the Fed created the bubble to end all bubbles. And when the bubble burst in late 2011, the game was up for Obama.
This, of course, is conjecture. Obama’s poll ratings remain reasonable despite the economy, and Democrats are confident moderate voters will be put off by the stridency of the Tea Party when they vote in the 2012 race for the White House.
And maybe Ben Bernanke has got his analysis right. Perhaps monthly injections of $75bn into the US economy are just what is needed to boost the money supply, to get credit flowing and to persuade companies to channel their cash mountains into investment. Bernanke’s worry is that growth and inflation are too low. Interest rates can go no lower, another stimulus package is a no-no given the Republican capture of the House of Representatives, so the only option is more quantitative easing (QE).
Actually, that’s not the case. The Fed could have sat tight to see whether the slowdown in growth in the second and third quarters of 2010 was temporary. Most of the economic news since the idea of more QE was first floated in August has been better than expected, if not exactly earth-shattering. Friday’s employment figures continued that trend. The Bank of England and the European Central Bank are adopting a suck-it-and-see approach, which doesn’t appear to be too bad a strategy.
Why? Well, consider the following factors. Firstly, the idea that the global economy is poised for an immediate double-dip recession is not born out by the statistics. Asia is booming, which is why India and Australia raised interest rates last week and why China is fretting about inflationary pressure. In part, that inflationary pressure has been caused by the first wave of quantitative easing, which simultaneously pushed down the value of the dollar, made the yields on US Treasury bonds less attractive and provided investors with ready money to speculate in other markets. Which is what they have done, driving up the price of oil, gold and industrial metals.
The falling dollar
QE2 will add to those upward pressures, and will also exacerbate the already serious global tensions over exchange rates. While highly critical of China’s manipulation of the yuan, the Fed is itself using QE to drive down the value of the dollar.
America’s rivals are going to see their competitive position eroded by higher commodity prices and a higher exchange, unless they either implement their own QE programmes, impose capital controls or raise tariff barriers. It is little wonder that Pascal Lamy, the director-general of the World Trade Organisation, has been raising the spectre of a return to tit-for-tat protectionism. Nor are the signs especially good for a harmonious meeting of the G20 in South Korea next weekend.
An additional problem for Bernanke is that any success he has in pushing down the dollar will make it more difficult to revive consumer spending at home. A weaker currency means higher import prices, so Americans can expect to see their discretionary spending power eroded by dearer food and fuel prices.
At root, the US has two problems – one cyclical and one structural. The cyclical problem is that the country has just endured the first nationwide housing crash in its history. That has led to millions of families losing their homes and millions more feeling less wealthy than they were when prices were booming. QE2 does little to address that underlying problem.
America’s structural problem is that it has been in long-term industrial decline for the past 30 years and is in a state of denial about it. Countries succeed when they get the fundamentals right: they see the need for the whole population to be well-educated, not just an elite; they spend time and effort getting products right and making small but important incremental improvements; they make things that other nations want to buy.
Germany has understood that; the US has papered over the cracks by allowing debt to balloon and bubbles to inflate. Each bubble has had to be bigger than the last in order to get the growth back to something considered acceptable, which is why the US went into this crisis with debt-sodden consumers and over-extended banks.
These weak fundamentals explain why the impact of QE1 on the real economy was modest, and also why many economists are sceptical about whether a second, smaller dose will do any good either.
Indeed, the US bears the hallmarks of what Keynes described as a liquidity trap, the point where neither ultra-low bank rate nor quantitative easing can persuade consumers or businesses to part with their cash. Trying to use monetary policy in these circumstances, he said, was like pushing on a piece of string; a better idea would be for governments to do the investing themselves through public works schemes.
But this is not going to happen. Policy makers had a brief flirtation with Keynes back in the winter of 2008-09, but are now intent on cutting deficits and balancing budgets.
That, then, is how things stand. There is a two-speed global economy; there is upward pressure on commodity prices; there is growing friction over currencies; and there are policies being pursued that are likely to do more harm than good.
In an ideal world, the new dose of QE is the touch on the tiller the global economy needs to see it through choppy waters to the calm seas ahead. But this is far from an ideal world; the ship is wallowing in stormy seas, and each violent turn of the wheel makes her more unstable.
The nightmare scenario, therefore, is that the Fed creates the conditions for the deflation it dreads. It is creating money to pay off its debts. It is knowingly debauching the currency. And it is fanning the flames of protectionism. The danger is that higher inflation pricks the bubble in the bond market, leading to a collapse in the dollar. Financial markets then tumble, the banks are plunged into fresh crisis, confidence collapses, and activity nosedives.
It’s a rerun of 2008-09, in other words, only worse because deflation is a reality, fiscal policy is shunned and international co-operation has been replaced by mutual suspicion and perhaps even outright hostility.
For the time being, the mood is upbeat. Oil prices ended the week close to $90 a barrel; the dollar’s trade-weighted index hit a low for the year; capital flows into emerging markets surged; the premium for holding risky assets collapsed. This may sound like good news but it isn’t. It is the harbinger of the next crisis.