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  • Jul 24, 2014
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Monitor
PUBLISHED : Thursday, 29 August, 2013, 12:00am
UPDATED : Thursday, 29 August, 2013, 4:42am

The Fed's policy is not just ineffective, it's catastrophic

Aside from prolonging the US slump, quantitative easing worsened China's investment binge and even triggered the Syrian civil war

On the front page of today's Business Post, my esteemed colleague Jake van der Kamp makes the often overlooked point that printing money doesn't boost your economy when people are paying down their debts.

The central bank can print as much money as it wants - which is pretty much what the US Federal Reserve has been doing for the last five years by buying bonds from the market. But the money it prints just ends up back on deposit at the central bank in the form of excess bank reserves.

As Jake argues, and as Japan learned 10 years ago, quantitative easing doesn't do any good.

But I'd go further than Jake on this one. Not only does quantitative easing do no good. The Fed's ultra-loose monetary policy has actually done immense economic harm both at home in the United States and around the world.

People should be dancing in the streets at the news the Fed is planning to bring this destructive policy to an end

Quantitative easing is to blame for delaying the US recovery, for exacerbating the mis-investment boom in China and even for triggering the Syrian civil war.

First, let's consider the impact the Fed's ultra-loose policies have had on America's real economy.

The original idea was that by cutting interest rates to zero and squirting lots of liquidity into the financial system, the Fed would encourage banks to increase their lending to job-creating small businesses.

But that's not how things worked out. As Ronald McKinnon, economics professor at Stanford University in California, points out, it is America's small local banks - which make up the vast majority of the country's 6,000 commercial banks - that are by far the biggest small business lenders.

Being small, these banks have limited deposit bases, which means they rely heavily on borrowing through the interbank market to provide the liquidity they need to fund their loans.

In normal times this isn't a problem, as big banks with plenty of liquidity are happy to make interbank loans.

But with interest rates within a whisker of zero, big banks see little point in taking credit risk by lending to small banks - 50 failed last year - for a minimal interest rate pick-up. They might as well leave their surplus funds on deposit at the Federal Reserve.

Of course, the small banks could bid to borrow at higher rates, but that would immediately mark them out as being in trouble, so they still wouldn't be able to get interbank funding.

So, far from boosting small business lending as the Fed intended, its ultra-loose monetary policy has ended up starving small companies of credit, undermining their capacity to create jobs and prolonging the slump.

Even if the Fed manages its exit from quantitative easing well, the long-term costs for the US economy are also likely to be severe. By pushing the yield on 10-year Treasury notes down to an average over the last five years of just 2.7 per cent, the Fed has blown a hole in many US pension funds, which typically had assumed their assets would yield 7.5 per cent.

As a result, towns and cities all over the US are now staring at default because of under-funded pension liabilities.

The July bankruptcy of Detroit with US$10 billion in unfunded health and pension liabilities to its retirees was just the start.

The negative effects of the Fed's policies aren't only confined to the US.

Once the risk of an immediate financial system meltdown receded in early 2009, zero interest rates and plentiful liquidity created an enormous carry trade, as capital flowed out of the US and into emerging markets, where growth and interest rates were higher.

To deter hot money inflows, China kept its interest rates low, which merely inflated the local property bubble and encouraged massive over-investment by local governments and state companies, worsening the country's economic imbalances.

Elsewhere, with returns on yield-bearing assets suppressed nearly to zero, speculative capital flowed into non-yielding assets, igniting a commodity boom.

Between the middle of 2010 and early 2011 the S&P GSCI Agriculture Index of crop prices doubled, pushing up food prices around the world.

With their economies already suffering from the downturn in Europe, and with their high proportions of young unemployed, Middle Eastern countries were hit especially hard by food price inflation.

The consequences were the mass protests of the Arab spring, which in Syria degenerated into an outright civil war which is now threatening to drag in Western powers, including the US.

And quantitative easing is largely to blame. So, far from complaining about tapering, people should be dancing in the streets at the news the Fed is planning to bring this destructive policy to an end.

tom.holland@scmp.com

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This article is now closed to comments

gkrause
I'm sorry Mr. Holland but the alternative you are apparently presenting as the preferred default option- letting the big banks fail and then recovering from there as the universe naturally unfolds- has been tried before, many times from my reading of history. The best known of these trials is the Dirty Thirties- basically 10 years of economic depression that was only relieved by the most cataclysmic conflict mankind has so far experienced. The fact that Big Corporations, including Big Banks, are indeed acting in a distinctly anti-social manner, bordering on (if not actually) sociopathic some would say, by hoarding as much of that liquidity as they can while proclaiming record profits, is a different story related more to an inherent fault in "traditional" Capitalism. The accumulation and relentless application of overwhelming power and influence, even if not explicitly vicious or brutal, is a highly effective competitive strategy when used to starve or otherwise pulverize smaller but more nimble and rising competitors. The same can also logically be used to effectively defend against regulatory constraint which is also something we are seeing more of. Perhaps China with its unique perspectives on social engineering, enterprise behaviors and consequences will be able contribute more of the needed insight and policy tools to keep behemoths from working at odds to the greater social good. We are all in this together and many feel that crunch time is not far away.
pslhk
jve’s enthusiasm about “reserves” is more infective than effective
in the discussion about a prognosis or pro forma obituary of qe
-
TH’s analysis is clear and consistent about qe’s effects
in the market on interest rate, fundflow, and prices
His focus isn’t on reserves which have,
as he merely noted en passant,
(swollen / intensified / inflected?)
due to the market’s lack of appetite
for investment / consumption
-
jve hasn’t explained why he is so overwhelmed by reserves
on which his tangled comments are either hackneyed or nebulous
Let’s see if jve may help us breathe easier and answer three questions:
-
(1) “they (Fed?) may … buy more money than they sell” (jve 8:14 on JvdK)
How exactly do they do it / why are there willing sellers of “money” to the Fed?
-
(2) What is the average / nominal / indicative spread between
what banks receive for reserves deposited in the Fed and
what they pay to attract the funds (for) deposit with the Fed?
-
(3) Answers to the above should help jve explain
the meaning / relevance / validity
of his belief “The reserves are a closed system”
in the discussion about qe’s effects on the market
impala
I have replied to your questions in the comments section of Mr van der Kamp's column of Aug 29, where you posted verbatim the same comment.
bluefirestorm
While I agree that QE is largely ineffective (i.e. banks aren't lending much, companies aren't really hiring and investing in equipment, wages are largely unchanged, and meanwhile zombie companies took the low credit rates to stay on a bit longer), it is a bit of a stretch to say that the food prices were pushed up solely by QE. There were severe droughts from 2010 in which both northern and southern hemisphere crop seasons were affected; thus triggering the fear of shortage and spike in food commodities like wheat.
captam
@"So, far from complaining about tapering, people should be dancing in the streets at the news the Fed is planning to bring this destructive policy to an end."
Well concluded Tom............... but be careful about the "dancing in the streets" bit.............. because in Hong Kong you might get arrested for failing to apply for a Public Entertainments Licence.
impala
Sigh here too. Mr Holland also doesn't understand monetary policy.

Apologies for perhaps sounding rude, but please, please do us all a favour and get this into your head. Pick up a textbook, read up on the internet, anything.

Private banks do NOT lend out the reserves they have at the Fed. The reserves are part of the monetary base (they practically ARE the monetary base). These bank reserves at the Fed are not effected by lending or not lending by banks to each other, or to other private parties.

The reserves are a closed system. They do not change because of any action a bank may or may not take. Only transactions involving the Fed can alter these.

When banks lend to each other, a lot may happen. But at the end of the day, the total in the reserve accounts with the Fed stays the same, unless the Fed conducts some transactions that alter it.

It is hard to get your head around it perhaps the first time, but please try. Don't confuse the monetary base and the (required and excess) reserves that it entails with fractional reserve banking's credit creation and quantity of money effects.

Yes, fractional reserve banking can expand money ad (nearly) infinum. Banks make loans to other banks, to businesses. Those loans are other people's deposits, which are used to make loans again. Capitalisation, bank leverage, the money multiplier and so on.

But this has very little to do with the monetary base. The monetary base is NOT affected by credit creation.
impala
And don't just take my word for it please.
An eloquent basic explanation contained in this post:
****ftalphaville.ft.com//2012/07/03/1067591/the-base-money-confusion/
 
 
 
 
 

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