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

PUBLISHED : Thursday, 29 August, 2013, 12:00am
UPDATED : Thursday, 29 August, 2013, 4:42am

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.