November 10, 2010
Bernanke's FollyBy Kerem Oner
The chairman made it official that the Fed will be implementing QE2 (Quantitative Easing) in the form of buying back $600 billion in U.S. treasuries. For those who need clarification, this translates in to monetizing our debt, which, by the way, Mr. Bernanke had testified to the Congress that he would not do.
The intended purpose of this foolish act is to nudge interest rates lower, make credit even cheaper, and consequently (it is hoped) jolt the faltering economy back into health by providing excess liquidity to the credit markets. Unfortunately, the unintended consequences, as Bill Gross of PIMCO -- manager of world's largest mutual fund company -- speculates, is 20% or more devaluation of the dollar.
This decision, which even some Fed members apparently disagree with, once again demonstrates Fed Chairman Bernake's incompetence/deviousness (the latter for those who are "audit the Fed"-type conspiracy buffs).
For any hypothesis (a proposal intended to explain certain facts or observations -- in this case, the alleged effectiveness of QE) to be tested for reasonableness, principles surrounding it and facts in the form of empirical evidence must bear it out with a great degree of certainty.
First, let's examine the premise itself, based on the following series of facts:
Fact: The U.S. dollar itself is the most significant non-human asset we have as a nation. It is still the single most important global currency.
Fact: Federal debt financing is conducted in U.S. dollars, through the sale of U.S. treasuries to domestic as well as foreign investors.
Fact: The dollar is backed by the good faith and credit of the United States of America since we went off the Gold Standard.
Fact: The U.S. manufacturing base has continually shrunk over the past fifty or so years, to the point where we are a service-based economy. Translation: We import a heck of a lot more goods than we export.
Fact: Should the dollar devalue, not only would it make financing the debt that much more expensive, but inflation would be unavoidable due to our dependence on foreign goods.
Fact: The U.S. federal government has a debt problem -- nearly $13.8 trillion at the federal level, to be exact. Looming over the horizon is another $111 trillion in unfunded federal entitlement liabilities, which cast further doubt on the good faith investors need to have in the ability of the U.S. government to honor its debt.
The above facts are undeniable realities that govern the consequences of any Fed action. Now, lets review empirical evidence as to the effectiveness of QE as a monetary tool to stimulate economies.
The two most prominent instances of QE being used are 2001-2006 Japan and QE1 (November 2008) in the U.S. (The Euro Zone has also tinkered with some variants of QE.)
In Japan's case, QE was used primarily to control CPI deflation. Many economist debate whether it has worked or not. I am in the camp of those who argue that it was the high oil prices of the period that ended Japan's deflationary problems. As far as the expansion of the Japanese economy during that period goes, it was largely self-financed by corporations' free cash flow and therefore not constrained by an absence of banks' lending. In other words, there was no real connection with the QE policy of Bank of Japan.
Finally, the FRBSF Economic News Letter of October 20, 2006 concludes that the outcome of the Japanese policy remains uncertain.
QE was subsequently tried in the U.S., starting in November 2008. The Fed supplied additional liquidity to the banking system to the tune of $1 trillion-plus. The expected $600-billion QE2 and any possible subsequent amounts will assure an additional $2 trillion or more liquidity to the U.S. banking system within the past two years. Unfortunately, the result has once again disappointed in that despite the additional liquidity, usage of credit has been lacking, as also witnessed by the worsening unemployment rate since the QE policy was undertaken by the Fed.
In conclusion, whether QE works or not is as unsettled as AGW (anthropogenic global warming). A static analysis of available data may suggest some success, but a more dynamic analysis would lead most observers to hold a healthy dose of skepticism.
As to the unintended consequence of QE2, application of basic economic principles suffice for abandoning the policy. QE, as its planned implementation suggests, will most likely cause the U.S. dollar to decline in value vis-à-vis other global currencies. It is a basic economic fact that printing money without creating corresponding economic activity in the form of goods and/or services debases a currency.
Finally, and perhaps most importantly, the reason QE will not work in this instance is that we do not have a credit availability problem. Our woes are based simply on a crisis of confidence. All surveys of businesses have consistently indicated that businesses small and large are nervous about the regulatory environment as well as the uncertainty over possible tax hikes. Corporations are sitting on nearly $2 trillion in cash instead of investing it, partially because of record low consumer confidence and partially because of the uncertainties this administration and Congress have created over the past two years. Simply put, no amount of liquidity will entice businesses to invest and create jobs -- at least not until the business environment improves.
As the true, real-world, practicing economic giants like Roubini, Gross, and Schiff (unlike academics like Krugman) say, allow the economy to restructure. Do not gamble away the reputation of the dollar in return for imagined short-term benefits. Superficial meddling will only dig our grave deeper. If these warnings are not heeded, as Mr. Roubini puts it, "the only light at the end of the tunnel so far is the one of the incoming train wreck, unfortunately[.]"