Does Beijing truly understand the Fed's QE plan?
The exercise of flooding the market with money that people in hard times don't want to borrow may result in quantitative hardening
China has called for greater consultation on the US Federal Reserve's plans to taper quantitative easing to avoid unnecessary risks to the global economy and disruption to currency markets.
SCMP, August 28
I wouldn't ordinarily bother with this sort of talk out of Beijing except that it is an echo of what is now being said by Christine Lagarde, a French labour lawyer who seriously undermined her country's fiscal position as finance minister.
This resounding achievement made her the obvious choice for managing director of the International Monetary Fund. Christine Lagarde loves to talk big at big talk shops but if she advises anything, be wise and place your bets the other way.
The first chart sets out the real economic risk here. It shows you that before 2008 the reserves maintained by US deposit-taking institutions were closely in line with the generally low levels required.
Then, in September 2008, the actual reserves suddenly shot up, to more than US$2 trillion now, even though the required reserve level remained modest. This represents what is called "quantitative easing", a programme of massive bond purchases by the Federal Reserve.
The reasoning had it that the US economy was in a spot of trouble and flooding the market with money through bond purchases would keep interest rates low and liquidity ample, thus allowing the economy to recover quickly.
Unfortunately, it contravenes a rule of the universe more basic than the Ten Commandments of Moses or the Four Laws of Thermodynamics - thou canst not push against a rope.
If people don't want to borrow money, then they simply won't, and in hard times people don't want to borrow money. What they want is time to pay off debt and get their personal or corporate balance sheets back in shape. Until that is done, they don't borrow.
And that is how things have turned out in the US. All that money is just sloshing around the financial system. As evidence, I present the second chart. The velocity of the money supply (GDP divided by M1) has come down sharply since 2008. If quantitative easing had actually kick-started the US economy, as it was expected to do, this ratio would have gone up, not down.
And now here is the danger. At some point the US economy will indeed revive, people will start making use of all that money in the financial system and then the Fed will have to sponge it up with a programme of quantitative hardening.
It is not doing so yet. It just says it may "taper" quantitative easing. But it may have to do a good deal more than this if it is to avoid robbing the savings of an entire nation through a blow-out of inflation.
That's the risk in good times of printing money heavily in bad times and it's a good question whether the Fed has the courage or the political support to raise interest rates sufficiently for the purpose when that time comes.
I wonder if they really understand in Beijing what is at stake here. I'm sure Christine Lagarde does not.