The problems have once again begun to build up. Gold prices soared to new highs on Wednesday even as there was renewed talk about a new round of monetary easing in the US, aka QE3. Both events are indicators of the continued nervousness in the financial markets about the immediate future of the global economy.
The last-minute deal in Washington to raise the federal debt limit was met with immediate relief across the world as the prospect of a US default receded.
Attention is now once more focused on the longer-term challenges facing the largest economy in the world. US president Barack Obama has agreed to put in place a mechanism to cut the budget deficit by $2.1 trillion over the next decade. More than $900 billion of spending cuts will kick in from October.
These spending cuts will likely dampen activity in an economy that is weakening once again. The US economy grew by a disappointing 1.3% in the second quarter of 2011 and the unemployment rate continues to be too high for comfort. The US economy is softening even as Europe continues to struggle with its sovereign debt crisis and Asian manufacturing growth is cooling off because of tighter monetary policies by regional central banks that are fighting high inflation.
It is against this backdrop that expectations of QE3 have grown. The fiscal austerity programmes in the US and Europe would ensure that governments cannot use their budgets to support their economies. The burden of stimulus will once again fall on the monetary authorizes, though unlike the first two rounds of quantitative easing, the price situation right now tends towards inflation rather than deflation.
Three former senior officials of the US Fed told the Wall Street Journal this week that QE3 would be likely only of the price situation is more benign, and also warned that such a policy is not a cure-all. These cautionary remarks are particularly important since the two earlier rounds of quantitative easing have left an uncomfortable legacy of higher inflation while providing only transitory support to economic activity.
The continuing problems in the Western economies will eventually needs structural reforms, ranging from raising their savings rate, rethinking the role of finance in their economies, and coming up with a long-term plan to attack what seems to be a deep-rooted structural fiscal crisis of the post-World War 2 welfare state.
Monetary stimulus will only be a drug, providing a temporary high. The financial markets do not seem to be fully aware of this reality.
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