QE2 could boost growth, but it will not

Below, I will spend some time explaining how the programme that the Fed will announce in a few hours could boost the U.S. economy, and why it will not do this.

With already more than two months since the Fed started talking about a new programme of money-printing (the economics word for it is quantitative easing, 2nd version, also: QE2), the list of opponents to QE2 is growing larger, and the list includes ever more renowed names. Examples: Volcker, Greenspan, Stiglitz, PIMCO's Gross, etc. All of them warn for medium- to long-term inflation dangers that will be a huge cost of the quantitative easing programme, whereas benefits are minor - that is, if they are there.

Nevertheless, the Fed will announce its QE2 programme today. Probably with monthly asset purchases of $100 billion, after each injection of cash reconsidering its next step dependent on the economy's progress. The Fed is hardly paying attention to the warnings, so it seems. Or actually, most members of the FOMC are 'not hearing evil, not seeing evil'. But yet, the Fed has never been so divided over what to do next. How come? The upcoming package of QE is unprecedented; there is no evidence of the effects of such programmes. All that Boom-Boom Bernanke is now seeing is that the Fed's dual mandate is out of sight. At least, when you look at the numbers superficially (more on that later). One mandate, an annual inflation rate between 1.7 and 2% is being missed. The other mandate, achieving close to full employment, is even further out of sight with a current unemployment rate of 9.6%, with risks of rising further as the government's austerity programme probably kicks in by 2011. Hence, the two targets are not being reached.

But there's more to this dual mandate. First of all, they are intertwined. The historically high current output gap that partly exists because firms are not hiring (thus, low employment), so capacity is not being used. This causes deflationary pressures. Get employment up, and inflation rises. Secondly, it is doubtfull that unemployment is cyclical and can be reduced by loose monetary policy (that is why it seems that the second target is being missed, but actually the mandate concerns cyclical employment as there is always some structural unemployment). As the U.S. economy is somewhat recovering, many people do not have the skills required by the sectors that are recovering, as they have been trained to work in sectors that are now declining. Looser monetary policy will do nothing to change this. Rather, retraining of workers, more flexible labour markets and changed legislation are needed. This argument has been advanced some speeches by Dallas Fed president Richard Fisher, who strongly opposes QE2.

So is the achievement of the dual mandate in the Fed's reach? Probably not, given current conditions.

However, the logic of Bernanke is the following (he, obviously, does think QE2 will help - somehwat): asset purchases lower interest rates, lower the cost of borrowing and create a wealth effect as firms and households see their balance sheets improve due to rising asset prices, whereas lower borrowing costs induce them to borrow more; hence, to spend more. This will create a domestic-demand-driven positive growth cycle. Companies will start to hire again once they see consumer spending restored.

But there are some crucial steps that need to be taken for this QE2 programme to succeed, which makes the plan weak. Some problems related to QE2:

• Interest rates are already very low. Even if the real interest rates get pushed down even lower, why would this now all of a sudden induce the consumer and business owner to start borrowing?
• Financial institutions are reluctant to lend. The normal transmission channel of monetary policy is broken. Lowering interest rates further does not automatically get credit in the economy up.
• As banks do not lend, they sit on a lot of cash that needs to go somewhere, so they invest it in higher-yielding (hence: riskier) assets. These high-risk yields get depressed as well, as can be seen already today, because of these capital flows into emerging market (EM) stocks and equities. This could lead to risks being significantly mispriced again, which was one of the causes of the recent crisis.
• It takes time to recover from a debt crisis. Consumers and firms took a blow as they saw their balance sheets destroyed. They are now reluctant to spend, and are seeking to deleverage. They just want to get rid of the debts! They do not want to invest; they want to save.
• Bernanke assumes that lower borrowing costs can get consumers/firms to borrow more (due to the substitution effect). However, lower borrowing costs imply lower returns from savings. Therefore, consumers/firms need to save even more to achieve the same return from their savings. It might well be that this income effect outweighs the substitution effect, by a lot. This is a big point. If it is true (I think it is), interest rates need to go up, not down, to get people to safe less.
• Following from the previous argument: As long as interest rates remain low, wealth gets shifted from consumers that save to financial institutions that borrow, whereas the consumers should be the ones to carry the recovery. Now they get deprived of returns to savings, whereas financial institutions that are actually doing pretty badly get to continue their operations. Higher interest rates would get less-efficient firms and financial institutions out of business. Keep borrowing costs low, and overall economic productivity stays low.
• Lastly, if the so-called 'wealth effect' is to take place, consumers/firms would have to genuinely believe in the restoration of their balance sheets from the increase in asset prices. If they think that higher asset prices are caused by the money-printing instead of asset prices rising from demand-supply forces, they will not start to borrow more againts their assets. In other words: if they think their houses etc. do not truly become worth more, they will also not lend against higher house prices, because they will foresee a new burst of the asset bubble.

And in the end, if these problems persist, and the Fed does not quickly undo the injection of money into the economy, inflation will be upon us.

This is a long list of negative effects and problems related to QE2. Monetary easing cannot lift the economy out of the doldrums. It is far too uncertain that QE2 will do any good, because of the hurdles discussed above, while the unintended consequences are possible enormous.

QE2 distracts people from the true problem, which is the unsustainable level of debts in 'advanced economies'. This problem should be recognised and attacked. However, given that the Fed proceeds with its nonsense QE2 programma, I hope the markets can get fooled. If not, QE2 will have no effect and the next (debt) crisis will be seriously damaging.

Finance ministers and policy games

Let me start the week with a new blog. So much has been going on recently (central bank policy, financial market turbulance - or a lack of it, indicating complacency -, international policy coordination - or a lack of it, especially when looking underneath the surface -, etc.) , that it becomes increasingly difficult to choose just one topic and elaborate upon it. Especially if, like me, you just want to read and know everything. Little time left then to reflect and write down your thoughts. However, that is what I will try to do. This time it's about international policy coordination, trade, competitive currency devaluations covered up as monetary easing, and the promises made during the G20 meeting last weekend.

Some good news after the G20 meeting of central bankers and finance ministers: the IMF's legitimacy was said to be enhanced by a shift of votes and quotas from the 6% most overrepresented to the 6% most underrepresented members. Great, of course, as it is a big surprise that the members agreed, but will this really change the way China approaches its diplomatic relations? Moreover, the problem of the illegitimacy of the IMF was just a top of the iceberg of problems that the political world-stage is dealing with today.

Just underneath the surface are currency issues. Although the Brazilian finance minister even mentioned a "currency war", it has not come this far (yet). For now, countries seem willing to cooperate. The G20 communiqué mentioned that: "we [read: the G20] will, continue to resist all forms of protectionist measures and seek to make significant progress to further reduce barriers to trade.", and "... continue with monetary policy which is appropriate to achieve price stability". Okay, this sounds good. Or, does it really? Monetary policy to achieve price stability? That is what the Fed is trying to achieve. However, it requires QE2 according to the Fed, and that is exactly what more the communiqué is saying countries should NOT do: "we will [...] refrain from competitive devaluations of currencies".

Unfortunately, the G20 lacks supranational power and the apparent willingness to cooperate might go no further than the communiqué. None of these agreements are binding. Moverover, since the dispute is mainly between China and the U.S., there is no member strong enough to exert the political pressure that would force them to come to a solution.

So China and the U.S. would have to come to a solution over the currency dispute on their own. And will this dispute get settled? Not if the U.S. keeps desiring fast Yuan appreciation in order to make Chinese imports less attractive and their exports to China more attractive, and if China maintains committed to very slow appreciation of the Yuan in order not to hurt the export sector's very thin profit margins and provoke social unrest. Overall, it is very unlikely that the dispute gets settled on its own, given that neither of the two is willing to give in.

And then there is the deeper lying issue of trade imbalances. The G20 communiqué shortly addressed this, by stating that the G20 will "strengthen multilateral cooperation to promote ... reducing excessive imbalances and maintain current account imbalances at sustainable levels". But since when are imbalances not excessive, and since when can imbalances be at sustainable levels? Apparently, leaders at the G20 could not agree on when, how, and why to address these imbalances that are one of the main causes of the crisis.

The bottom line is that the deeper lying issues will not get resolved. The path of the least resistance is that countries (the U.S. first, and other countries could follow) resort to some kind of protectionism. Either in the form of trade measures or in the form of quantitative easing. The first is less likely to occur, as the biggest and most efficient U.S. companies are the ones that engage in exporting and importing, and precisely these profit-generating firms stand to loose from this. Given their large profit-making potential, it would be a very silly move. Nevertheless, it would not be the first time that politicians made silly moves (silly being a heavy understatement) .The second option, quantitative easing, is more likely, even though the G20 communiqué explicitly tells countries to refrain from competitive devaluations of currencies. The Fed, for example, can resort to its dual mandate to explain the need for further monetary easing and claim that devaluation of the U.S. dollar is just a side effect. Nobody in the real world, obviously, believes this, but it is just part of the political game.

Note to "Bad news is good news"

No matter how strongly I believe that further quantitative easing will not help the U.S. economy move forwards, this does not mean the Fed will not engage in QE2, unfortunately. I believe they have gone down a road and now cannot turn back, because:

• Markets have priced in a large amount of possible further easing. Announcing no or only little QE2 will shock the markets, but in the wrong direction (stocks, gold and commodities will decline);
• The first round of QE helped (although back then loose monetary policy served the completely different purpose of providing liquidity to a system in need of liquidity);
• With fiscal policy offering little help, the Fed must do (rather: try to do) something (it's in their mandate);
• Future disadvantages to QE2 are far away, and very much unknown (unknown also are the benefits, but hey...), and;
• Bernanke is in favour of QE2, and so are most Fed members (and Krugman)

With this in mind, I think it is just much more likely the Fed will announce on 2-3 November a shocking package of purchases of government bonds and private assets.

Bad news is good news

The title of one of my previous blogs was 'No news is good news' and it mentioned the market's reaction to what was actually nothing new. The blog dates 20 September: just after the Fed's remarks that the economy showed no substantial signs of improvement and they would wait and see what would happen with economic growth in the coming months. Market sentiment was positive, although there was in fact nothing to be positive about: the outlook was just as bleak as before.

Today, the outlook is just as bleak, if not worse. However, the Fed is seriously contemplating QE2. Good for the stock markets and commodities and for these markets, a substantial amount of the by-markets-desired-$1trillion-at-least-of-QE2 has been discounted in market prices. A poor nonfarm payroll number last Friday made markets more confident that the Fed will give them 'their money' and subsequently, stock markets rallied. Hence, for the markets, "bad news is good news".

However, in a speech of Dallas Fed president Fisher, Fisher hinted at markets being overly confident about Fed starting a second round of quantitative easing. Payrolls are not expanding, because businesses as unwilling to hire as they experience too much uncertainty regarding future taxes and regulation, but they are aware of the fact that some day in the future, taxes will have to be raised to finance the huge government debt. In this environment, the Fed cannot do anything to bring down unemployment. If anything, they only contribute to more uncertainty and thus higher unemployment. So far for one goal of their dual mandate. More on inflation next time.

Moreover, liquidity is abundant and more liquidity is not needed. It helped in 2008 when the financial system was experiencing a lack of liquidity and the Fed had to step in to address this market failure. But now, only a very small amount of businesses find they are credit constraint, and probably the Fed cannot overcome this. They have done whatever they have to do. Now it's time for the Fed to get their hands off of it and let Congress, now matter how divided they are there, do its job.

Will politicians be able to avert prisoners’ dilemma outcome amid pressures? Currency war debated.

During the last days, attacks on Chinese exchange rate policy (regarding the undervalued Yuan) have become more intense. After the U.S. had ignited the debate by introducing a Currency Bill that would give the U.S. the right to levy import tariffs over Chinese products that are too cheap due to the export subsidy in the form of the undervalued Yuan, other countries were asked to join the debate. Once the Currency Bill has passed Congress and Obama put its signature on it, China can take the case to the WTO. Then, it might take months before the issue is settled, and in the mean time, other countries might have followed the U.S. example, damaging Chinese exporters. Since the chances that the Currency Bill will not be condemned by the WTO are much higher if other countries follow the U.S. example, the EU has strengthened its tone vis-à-vis China to make its exchange rate regime more flexible in practice (currently, it’s only flexible in theory). (Asking the Europeans to introduce an equivalent to the U.S. Currency Bill is perhaps a bit too much.)

But the Chinese are not stupid; they offered Greece a Marshall Plan II whereby China is buying Greek bonds (while saying they strongly believe in the good economic fundamentals of the country and the Euro zone) in return for Greece buying Chinese products. By supporting the weaker countries in the Euro zone, they ensure the strength of the euro, and thereby they retain an investment alternative to the U.S. dollar and an export market. Moreover, it implicitly tells the EU that it should not complain. The EU has gotten one cookie, it should not ask for another one. So now the EU is said to back off when it started complaining about the Yuan weakness.

So this move by the Chinese was very clever, in my opinion. However, do they really have a right to ignore global complaints about the weakness of their currency? IMF studies, and other ones, agree that they Yuan is 20-40% undervalued. If that’s not an unfair export subsidy, what is?

More and more countries seek to devalue their currency by intervention and/or loose monetary policy. Research has provided ample evidence unsterilised intervention is only working when accompanied by a loose monetary policy (and sterilised intervention is actually never working, perhaps only in the short run, and it can even be counterproductive, due to signalling effects). However, it is not always possible to loosen monetary policy. Japan has loosened monetary policy for years and is at or near the zero interest rate bound for years now, without having lifted Japan out of its period of (near) deflation.

Furthermore, it just is a very bad idea to try and weaken your currency, if all your neighbour countries have the same idea. When visitors on the first row of a concert start standing on their toes to have a better view, visitors on the second row have to come up with something better. Maybe jumping does the trick for them. But the ones at the back row really have a problem. This is the outcome of the well-known prisoners’ dilemma: nobody will have an advantage from it (the ones at the first row will start experiencing aching toes after some minutes and will regret their actions).

This is obvious: if each country seeks to lower its currency, flooding the market with liquidity, no country will succeed to lower its currency relative to the other countries. Except, of course, if one country takes such extreme measures that this immediately wipes out the value of its currency. Hyperinflation will prevail. Perhaps it is good – albeit only relatively good – if one country would follow this course, just to set the (bad) example.

Luckily for us Europeans, it is unlikely that the ECB will be the first one setting the bad example; the ECB is farthest from all central banks of the weaker countries to engage in extreme further quantitative easing, although the ECB did admit banks were addicted to their liquidity provisions such that the ECB has seen its exit doors (their path to tighter policy) being blocked.

The big question is, however, how far countries will go. There is a slight chance that central bankers and politicians do not realise the game they are playing is a very nice example of this prisoner’s dilemma. One step in the wrong direction, and the prevailing outcome will not be likened. In the end, every country will be worse off. Political pressure to purposefully devalue currencies, unfortunately, is enormous. I (being an optimist) do not believe central bankers will be so naïve (read: stupig) to underestimate the dangers going “all out” and continue the road (downhill) of extreme QE and currency devaluation.

But perhaps I am just being optimistic, believing in the wisdom of politicians and central bankers. And that is perhaps not so wise.

My personal assets and liabilities

A conference this morning in Amsterdam. Interesting, a lot of macroeconomics, international economics, monetary economics, a lot of men in expensive suits. Still, something else has been playing on my mind. There is something inherently wrong in the idea of economic growth we have. This sounds a bit radical, maybe it is, but I think it is crucial for how we view the world around us.

A side note: we, economists (yes, I consider myself an economist), tend to think the whole world evolves around economics. Maybe I believe this idea is more important than it actually is, but perhaps - especially if you are also wondering what this think we call economic growth actually is - you can agree with me.

Another side note: the gut feeling I have is difficult to put in words, but I'll give it a try...

Let me start with what is going on in the markets and what a very important dilemma is that we are currently facing.

On Tuesday evening, Fed chairman Bernanke said that inflation in the US is below the Fed's target. Since the Fed has the dual mandate of keeping employment at its maximum hurry, as long as it does not hurt its other mandate of price stability, the message of Ben actually implies that the Fed will engage in another round of quantitative easing (QE II) if it sees further dangers to price stability. Hence, more liquidity injections will be advanced by the Fed to prevent deflation. When and in which way the Fed will do this is another uncertainty to which it has not given an answer (not yet at least; tonight Bernanke will give another speech with the topic what the Fed can do to stimulate the economy, speeking about which courses of action are likely and what the accompanying dangers are). However, this is outside the scope of what I'm trying to describe here.

The whole idea of the Fed is that they will provide more liquidity in order to support the economy. This money is very likely to go into assets directly, and this will unavoidably lead to increases in risky asset prices. So will this support the economy? Will this produce economic growth?

There are some conditions that have to be fulfilled, should a monetary stimulus (QE) boost economic growth, and these conditions are quite stringent:

• Liquidity should flow from the banking sector to the real economy. Hence, consumers should receive this liquidity (the banks should be willing to lend, so their prospects for receiving this money back should be sufficiently positive);
• Consumers that receive additional money should be credit constraint. That is, they have to be willing to spend this money, instead of using it to pay off debts;
• The money the central bank seeks to pump into the economy should not be directed to, for example, risky assets or commodities (gold, etc.).

If this happens, money that is created by the central bank does not stay on the balance sheets of commercial banks, but is lended to consumers, who spend this extra money. Consumers would consume, and this increase in demand would be met by additional supply.

However, increased demand for any good will certainly be accompanied by price increases. Retailers must be crazy if they would sell their products for the same price as before, while consumers received "free" money. But most importantly: there is no free lunch!

So the fourth condition for monetary stimulus stimulating growth is that prices should not rise.

Now, assume that the enormous monetary stimulus of the past two years has not created money flows into equity (increasing equity prices) or into safe havens (gold, whose price has soared, and government bonds of countries considered safe, pushing their yields to historically low levels), but consumers would have received this money, would not have consumed even more than before, and supply would have risen simultaneously. Then, we would have been back at the old situation of too much debt accumulation.

It seems that in the past, we have consumed already too much. The problem is not that now there is a lack of aggregate demand, the problem is that in the past there has been excess demand, and this was financed by borrowing, not by an increase in our own production.

So in the end, what it all comes down to, is the following:

Over our lifetime, we should contribute just as much to the economy as we take out of it. We must produce just as much as we consume. In principle (and in the long run), the balance sheet of each person, over a lifetime, should be balanced: assets equal liabilities, and there is no debt nor saving surplus at the end of a person's lifetime. Unfortunately, this is not what has been happening.

So what must be true then, is that we (us, in the West) have borrowed, from foreigners, from future generations, from the world. We are not producing in value terms as much as we are consuming.

In the train yesterday, I overheard a conversation of a woman saying that actually they were working really hard at her company. She works 36 hours a week. I am sure that she is spending more in the other 132 hours of the week than what she truly produces in value terms during the 36-hour work week.

Looking at my own balance sheet, I must admit that I have taken much. My liabilities are composed of: a laptop, a netbook, DVDs, books, a TV, CDs, my phone, the Wii, a not so small student loan, shoes, clothes, etc.. On the other hand, there is just one true asset that I have been accumulating over my lifetime: human capital.

My human capital must be truly enormous if I could have bought with it all that I own. Sure, this is called investing, and I seriously hope that I will add a lot of value to the asset side of my personal balance sheet in the future .

But still: our liabilities are huge.

No news is good news

Finally, a new blog post of mine. The last weeks have been filled with work, study, some volleyball (the preparations for the season were more than great, now let's hope our team can keep this up), and a lot of time spent on the preparations of the General Members Meeting of my volleyball club taking place in two weeks. After that: no longer Ms President of the Board for me. A short, early reflection: it has been a very good experience, but it has been a rough ride as well!

Luckily, during the past few weeks, I had some time to reflect on the economy as well.

Conclusion: nobody knows what is going on anymore! However, very few people are willing to admit this. (What makes even me so sure that nobody knows, and if that is true, I do not even know whether it really is true. Annoying.) And that makes sense. Image what would happen in Ben (Bernanke that is) would say: "Guys, I don't know whether it will help, but let's stuff another huge pile of money into the economy (or in the banks, who do not want the money anyway) and see if tomorrow or next week it can stimuate job growth, housing prices, and thereby economic confidence". Nonsense of course; this will not happen in a million years. At least, I hope it will not.

But let's assume that Ben would say this. The market's logical reaction would be to abandon the USD, and move into safe assets such as gold. The gold price will rocket, perhaps with prices of other safe assets (a more difficult question is which assets will be safe in such an event, perhaps there will not even be one considered safe). The US will face a currency crisis. Banks with substantial assets priced in USD will fail, and this will lead to contagion of other banks, with soon enough really negative consequences for the real economy. In other words: economic disaster.

However, the big question is: why is this scenario so different from what is happening today? As the Fed announced nothing new yesterday; its outlook has not changed and they are still waiting to see in what direction the US economy is heading before they decide whether or not to renew their quantitative easing efforts. Hence, no news.

The same goes for the US housing market. Figures were released on homebuilders' confidence, which remained at the same level as previous month - albeit weakest level in more than a year-. Hence, no news.

Still, market sentiment was positive today. No news is good news? At least the Fed did not announce that the overall economy was getting worse and QEII was required, and also the housing market did not become worse. And this is supposedly good news.

Right.

In some other column, I wrote that this is can be called a bias in human nature. We have seen so much bad news, and perhaps even become immune to bad news. Although bad (or mixed) signals are abound, they are not breaking news anymore. And therefore, it is easy to get optimistic when some good signals show up, which is also what everyone is hoping for.
We even perceive the not-all-too-bad news as good news nowadays. Perhaps not surprisingly, but does it really make sense? The economy is still very unstable.

Market psychology is interesting. Maybe more on this next time.

FAQs part II

In my last blog I posed some questions for which we still don’t have a (more) definitive answer, except perhaps for the first question. With the Fed taking steps to quantitative easing 2.0 (albeit baby steps, since for now it has announced only to maintain the size of its balance sheet, and not let is shrink – indicated by the FOMC’s public statement last Tuesday), the markets are certainly not responding enthusiastic. More accurately: the past week has been a very hectic week for the financial markets. Worries about the recovery in the U.S. spread to more concerns about mainly the periphery of Europe. German export-led growth for now pulls the Eurozone ahead, but how long will that last? Quarterly growth was well above expected, but if countries importing German goods see their economies weaken, German growth will be unable to sustain itself. The ECB has indicated it will slowly move to exit strategies. Although problems in the periphery are still very concerning and dependence of banks in Portugal, Spain and Greece on ECB financing is increasing steadily.

The Fed, on the other hand, is much more willing to support the economy with an even looser monetary policy. Analysts and commentators alike are very pessimistic about the effectiveness of further quantitative easing. If it has not worked in the past, why would it work next time? Is there so much more the Fed can do? Well, actually, yes. But that is just in theory. Central banks worldwide are constrained by the whims of the market. Should a sudden worry for hyperinflation pop up, better beware! If central bankers do not respond quickly taking the money out of the system within a week or so, double-digit inflation may be the result.

But for now, the Fed is walking a very thin line between high inflation and deflation. Core inflation in the U.S. (excluding food and energy prices) is already in negative territory and should economic activity not pick up, negative annual core inflation is not unlikely. Of course, for a large part this is driven by the still declining housing prices. Nevertheless, deflation is a dangerous phenomenon and Ben Bernanke will do everything in its power to prevent it, but he has not indicated directly what he will do should the economy get even worse. If such measures are taken (the measures the Fed could possibly take are in an earlier blog of mine), however, the market will interpret this as a sign that the economy is doing really, really, really, really terrible. No need to explain here what that means. But on the other hand, when signs of the economy weaken, and the Fed does not respond, the markets will also react negatively.

My overall conclusion therefore is: whatever monetary policy does, it will not improve the matter much (the matter being the U.S. economy), and it is fiscal policy that should get things going again. But please not in the way fiscal policy has been used in previous U.S. fiscal stimulus packages. Let’s look at China; they really set a good example.

More on that later.