US Fed's QE3 stimulus may do more harm than good
Andy Xie says the US Fed's latest round of monetary stimulus won't heal the economy, and may well actually worsen the malaise by injecting uncertainty about inflation into the market
QE3 has finally arrived: the US Federal Reserve has promised to buy US$40 billion of mortgage-backed securities a month for as long as it deems necessary to revive the economy. QE3 is QE Infinity! Will it end with a thriving economy or a catastrophe? Remember, it was former Fed chairman Alan Greenspan's "Midas touch" that brought us the dotcom bubble, the property and financial bubble, and the global financial crisis. Will Ben Bernanke's so-called "quantitative easing" take us to a better world?
The mere fact that this is the third round of quantitative easing tells us the limited effectiveness of such a policy. Between February 2008 and August 2010, the US economy lost 8.7 million jobs, though it has gained 3.4 million back. By contrast, between 2004 and 2007, the US economy created an average of about 2 million jobs a year. The Fed bought US$1.6 trillion of assets through the first two rounds of quantitative easing.
Yet, still, the US labour market hasn't performed. Of course, one could always argue that it would have been much worse without the Fed's action. We will never know.
What we do know is that food and oil prices have been rapidly rising despite a weak world economy. Statisticians in the US and China don't see much inflation. Yes, the price of my bowl of beef rice may be the same, but the beef on the rice has been performing a vanishing act. Do the statisticians feel hungry?
Wall Street is grateful for the quantitative easing. Internet stocks are bubbly again. Bond prices are rising, increasing the value of the main asset the big banks hold. Commodity prices go up and down with the coming and going of quantitative easing, creating opportunities for traders to get rich. Wall Street is supposed to allocate resources efficiently. It is doing little of that nowadays. Turning the market into a casino has become the main business. The Fed runs the economy through financial markets; is that helping efficient allocation?
This open-ended quantitative easing is supposed to give business confidence that the Fed is committed to improving the economy. American businesses have historically high levels of cash. If they invest the money, employment will rise, demand will follow, and businesses will make money. The Fed is convinced that the virtuous cycle can be activated if confidence is regained. Will businesses take the bait and invest?
I doubt it. Quantitative easing creates massive uncertainty. Bernanke is a follower of Milton Friedman who famously remarked that "inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output".
Bernanke reassures us that, when inflation becomes a problem, he will take back the excess money to rein it in. However, that would trigger a massive recession. His promise to accommodate some inflation may not be credible. Keeping cash may be the best choice for businesses. Even though investing may create a virtuous cycle, it may not last. The Fed's tightening - when it comes - could cause a massive recession. With demand expected to fall, it doesn't make sense to invest even though business could be good in the short term.
Financial investors are responding to the uncertainty in extreme fashion. Some are holding bonds despite near-zero interest rates, because they believe the Fed would crack down on inflation. Some are holding gold to hedge against the scenario that the Fed would accommodate it. So, the gold price screams inflation, while the bond price says deflation. Such uncertainty cannot be good for the global economy.
The US economy suffers structural problems that cannot be solved quickly. The jobs that were created during the bubble economy won't come back. Most unemployed workers will have to do something different. The retraining and matching process will be slow and long. Indeed, people will have to take lower wages to get a job. These wages could be too low for them to remain in the labour force. After a big bubble, an economy takes a long time to heal. Stimulating it with quantitative easing may bring more harm than good.
Central bankers have been overreaching for a long time. Their actions in curing economic ills have laid the seeds for the great catastrophes the global economy has experienced. The Latin American debt crisis in the 1980s, the Southeast Asian debt crisis in the 1990s, and the global financial crisis in the past five years can all trace their origin to the Fed's earlier actions.
What Bernanke is doing could lead to another great crisis, probably a global inflation crisis. Its consequences may be protectionism and the reversal of globalisation. In cleaning up Greenspan's mess, Bernanke could do even more harm.
Andy Xie is an independent economist