The Federal Reserve, its actions being carefully mediated by the news media in the name of shaping economic expectations, has embarked upon what is known as Quantitative Easing take 2 (QE 2) in Washington’s economic soap opera. Federal Reserve Chairman Benjamin Bernanke himself took to The Washington Post’s op-ed pages to explain his highly technical actions in plain English, as if there is a difference.
The Fed’s economic technicians, led by the Fed Chairman himself, fearing deflation, the story goes, want to reflate the economy to prevent another recession: to raise prices by making more money chase fewer goods, stocks and other financial assets. Bernanke calls this creativity. The self-serving adulation of the Fed cannot be any more unabashed.
This time, as if the Troubled Asset Relief Program (TARP)―which had relieved Wall Street of the troubled assets while burdening Main Street with them―was not enough, Bernanke’s idea was to supposedly lower the rates on Treasury bonds which mature in the longer term, ironically, to narrow the spread on the yield curve which works to discourage investment and hence, job creation: a recipe for a double-dip recession. The Treasury will pay out less but could also take in far less because of slower growth, increasing the budget deficit some more.
The White House has every reason to be livid because the potential deflation, which could be caused by jitters in consumer spending due to high unemployment and high employment uncertainty, is because there is not enough domestic investment to create sustainable job growth, albeit a recovering economy, recovering primarily because of jobs and consumption among the top 20 per cent of income earners.
The second tranche of freshly printed U.S currency to go beyond the zero bound (or the zero federal funds rate) of $600 billion to follow the earlier $300 billion is on its way to the cash deluged streets of lower Manhattan, leaving the United States up to its eye balls in debt and knee deep in a monetary flood. Economists call this the liquidity trap. To add to this woe, unlike in the ’90s, American consumers themselves are in deep debt, and feeling wealthy on stock paper in the retirement accounts from which they are drawing to consume is not going to help this time around.
When banks are motivated to borrow short at a lower rate and lend long domestically at a higher rate, domestic investment rises. When that spread narrows, domestic investment is further squeezed. Therefore, it is natural to expect the financial markets to take their cheap dollars out of U.S Treasuries and put it where the yields are higher: in the growing emerging market bonds and stocks, besides some money trickling into U.S stocks. The financial markets will borrow short in the United States and lend long abroad. Investment elsewhere will rise, both in financial assets and in real assets. This will continue as long as the cheap dollars are in abundance bringing about the feel good days of the ‘90s elsewhere in the world. Globalization, however, is not about exporting cosmetic economics and to raise expectations of a better life that does not last because they are false.
The ironies of the Fed’s hands off and unconditional approach to monetary easing do not end here. Given the lower yields on U.S debt, foreigners will also begin to start selling U.S Treasuries in exchange for cash to park it in higher yielding financial and real investments. If underlying U.S economic fundamentals (a.k.a real domestic investment) do not improve, the confidence in the U.S dollar itself will begin to fade, triggering foreigners to take those dollars to the currency markets to exchange them for other currencies.
The perverse effect of such a cascade of market reactions would be to raise the yields on U.S debt. To keep the yields low the Fed will have to keep buying more and more. And all of that cash, in the absence of real investment, will create a financial asset price bubble with which the Fed is flirting at the moment because it thinks it has some leeway on inflation before the higher financial asset prices raise other prices to raise inflation.
How can the Fed forecast if the economy will be in an asset price bubble? Because it is creating one under the spell of the ‘90s nostalgia. The year is not 1993. It is time to get the real jobs back by doing real things for real Americans.
QE2 is needed to cross the ocean of economic despair, but it matters how that ship is steered if it is not to become another Titanic.