The US Federal Reserve is desperately trying to fix the economic system that broke down in 2007. What was this system? It was, simply put, an economy that thrived on debt. Incomes in the US were skewed in favour of the rich, while the poor got skewered. So how do you ensure demand for the goods and services that businesses produce when real incomes remain stagnant for decades? The system did that by two methods—it relocated production to the emerging countries, where costs were very cheap, thus allowing final prices to be low while keeping profits high; and it piled on debt to consumers by keeping interest rates low. But how can you keep adding debt if incomes don’t rise? You do it by inflating asset prices. Higher asset prices make consumers feel they’re richer. In the US, house owners used their homes as piggy banks, borrowing against their rising values, while the paper profits generated by a rising stock market also helped people spend. This was the economic edifice that collapsed during the bust of 2007 and which the Fed is frantically trying to rebuild. The New York Fed’s Brian Sack underlined the rationale for QE2 (Quantitative Easing 2) recently when he said that “balance sheet policy can still lower longer-term borrowing costs for many households and businesses, and it adds to household wealth by keeping asset prices higher than they otherwise would be”.
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That is the whole point of QE2—to get the old system up and running again by increasing asset prices, which would create a wealth effect which would induce consumers to borrow and spend. As PIMCO boss Bill Gross put, “Has there ever been a Ponzi scheme so brazen?”
Could it work temporarily, though? It might, if it succeeds in boosting asset prices. The US Fed doesn’t expect the unemployed in the US to go out and spend. But consumption in the US is heavily skewed in favour of the rich, with the top 20% being responsible for 65% of the consumption, according to Citigroup analysts. The Fed’s gamble is to make these Americans feel richer, through higher asset prices.
But stocks and bonds have already factored in a large boost from QE2 and the question is whether it’s already discounted. The yield on the US 10-year treasury note, for instance, has bounced back from the low of 2.41% seen in early October and was at 2.66% on 1 November. But then, with the fiscal conservatives becoming stronger in the US Congress, President Barack Obama has little choice but to use monetary policy and we could very well see larger and larger doses of QE.
The trouble with lower rates of interest in the US, however, is that investors will move into non-dollar assets, which will inevitably reduce the value of the dollar. The US dollar index has already fallen from 83.16 on 31 August, around the time the speculation on QE2 started, to 77.3 on 1 November. If QE2 succeeds, it will devalue the US dollar even further. That may be eminently desirable for US exports, but what does it mean for emerging markets?
To gauge that, take a look at what happened during QE1. On 25 November 2008, the Fed announced QE1, a plan for buying $100 billion of agency debt and $500 billion mortgage-backed securities (MBS). The 10-year yield fell from 3.35% to 3.02% immediately. But the shock of the Lehman Brothers collapse was still fresh and investors sought the refuge of US treasuries. Although the dollar index fell initially, it rebounded to a new high in early March. On 18 March, the Fed enlarged the scope of QE1, by increasing purchases of agency debt to $200 billion, MBS to $1.25 trillion and added another $300 billion of treasury securities to its purchase plan. The dollar started its long slide shortly thereafter, falling to a low of 74.7 at the end of November 2009. We all know how asset prices zoomed since March 2009. Commodity prices also moved up, with the Reuters/Jeffries CRB index moving up from a low of 200 in early March 2009 to 283 by end-December.
If it works, QE2 should have the same effects. The problem for India is its sensitivity to rising commodity and oil prices. The Fed wants a return of inflation in the US and a paper by three Fed economists in September argued that “if the increase in oil prices is gradual, the persistent rise in inflation can cause a GDP expansion”. Note that the Reuters/Jeffries CRB index is now at its highest since the recovery began. That’s the danger from QE2 that India faces.
For the world economy as a whole, the attempt to put a faulty and broken system on the rails looks a lot like madness, setting the stage for an even bigger crisis even if it succeeds. Who was it that said insanity is doing the same thing over and over and expecting different results?
Manas Chakravarty looks at trends and issues in the financial markets. Your comments are welcome at firstname.lastname@example.org