Trapped in a QE black hole
As China's economy stalls and an expected US rate rise fails to materialise, the world is trapped in the orbit of a quantitative easing black hole
Lost in all the noise and chaos of the recent surprise devaluation of the yuan is an understanding of what might have been said behind the scenes between the US Treasury and the People's Bank of China. It would be surprising if the officials at the Federal Reserve or US Treasury had not been consulted by their counterparts at the PBOC before embarking on a significant devaluation.
Members of the Fed may not have liked what they heard, but they were probably informed about the PBOC's intended course. After the 2008 global financial crisis, central banks have coordinated policies, goals and actions closer than ever.
Ever since the Japanese emerged as big holders of US dollars in the 1980s, coordinating exchange rates and the purchase and sale of US treasuries became a necessity. Remember the Plaza Accord in 1985, an agreement that managed a 51 per cent depreciation of the exchange rate between the US dollar and the yen to 1987?
Today, different problems face central banks and their economies. But the same old tools aren't working in a globalised economy, especially with China's newfound influence. So the PBOC (and investors) need to confront the inescapable orbit of the quantitative easing black hole that the US has delivered us into.
There is one intriguing theory that has so far garnered little attention: that the yuan devaluation was only a reaction to front run the suspicion that the US was unlikely to raise interest rates as its promise of QE tapering. Or maybe the Fed never intended to raise rates at all.
It's not a conspiracy theory because the second-half recovery the Fed has hoped for doesn't look like it will occur. And that poses a dilemma for policymakers and investors.
QE has defied withdrawal for almost seven years. Yet every fund manager prepares for its eventual withdrawal and talks about it in their presentations as if is a temporary programme. They are not prepared for the reality that because of a stubborn US recession and an unsatisfactory economic recovery, we may be living in a permanent QE world. That means more financial and real asset distortions, heightened volatility and a risk of more market meltdowns.
But the cure is worse than the illness. Raising interest rates by even a small amount could be hazardous. The Fed is trapped because a 0.25 per cent increase in rates is equivalent to US$45 billion in additional interest payments for the US government. Indeed, if interest rates are normalised to 6 per cent, payments on the national debt would rise to a scary US$1 trillion.
Despite persistent warnings from Fed officials that QE is ending, it is conceivable that interest rates will never become normal again in our lifetimes. Only managed or outright default through a massive long-term decline in the US dollar or a major restructuring of treasuries can reset the economic model. Unfortunately, those alternatives ultimately require a precipitous drop in the standard of living - like in Greece.
Hard to believe? Lawrence Summers actually argued last week for more QE saying, "A reasonable assessment of current conditions suggests that raising rates in the near future would be a serious error that would threaten all three of the Fed's major objectives - price stability, full employment and financial stability."
Another QE is probably needed, but the funding must be targeted to increase aggregate demand. The money has to be directed to small- and medium-sized businesses and individual workers.
Any liquidity and stimulus cannot be controlled by banks. The current QE has shown that banks lend to people who do not need it and do not lend to those who do. Ironically, QE might cause deflation by encouraging investment and speculation in real and financial assets over production and employment, thus widening inequalities in income and wealth distribution.
So against the backdrop of a stalling Chinese economy run by an inexperienced central bank trying to internationalise the yuan versus a grotesquely indebted US government run by experienced central bankers who are facing an impossible dilemma, the world turns.
