One outcome of the U.S. midterm elections is that the results have effectively marginalized the executive branch when it comes to dealing with the economy. The debate over stimulating the economy versus shrinking the deficit has been concluded and the winner is . . . paralysis.
The GOP majority in the House of Representatives will prevent the government from taking substantive action. Any hope for goosing the economy will have to come from the Federal Reserve. The Fed has taken up that challenge with its decision last week to pursue another round of quantitative easing. It is not clear if “QE2,” as the move is known, will do the trick. If it does not succeed, the United States could be running out of options.
The U.S. economy grew 2 percent in the third quarter of 2010. While that is an increase from the previous quarter, it is not enough to reduce persistently high unemployment of 9.6 percent. As the record $800-plus billion stimulus of two years ago winds down, consumer confidence remains low, savings are too high and the private sector is sitting on growing profits rather than investing them. There is not enough energy in the economy to create a virtuous circle of steady growth.
Typically, in this situation the government would step in with Keynesian stimulus measures, but the lesson Washington appears to be taking from the midterm elections is that the government should now focus on deficit reduction and balancing the budget. Normally the Fed would step in to loosen monetary policy — lower interest rates — to spur lending and hence spending, but short-term lending rates have been effectively zero for months. Thus, the Fed would be “pushing on a string” to stimulate the economy.
As an alternative, the Fed can try “quantitative easing,” whereby it actually pumps money into the economy in an attempt to spur activity. In early 2009, it purchased more than a $1 trillion worth of Treasury securities and U.S.-backed mortgage-related securities, which led to reduced interest rates and pushed the economy to 5 percent growth by the end of that year. At its last meeting, held on Nov. 3, the Federal Open Market Committee, the Fed’s monetary policy committee, decided to buy $600 billion in longer-term U.S. Treasuries over the next year in an another attempt to inject liquidity in the market.
When combined with a program announced in August by which the Fed will buy Treasury debt of $250 billion to $300 billion by the end of June, total purchases will reach $850 billion to $900 billion, or almost as much as the stimulus package passed by Congress after President Barack Obama took office. That is the source of one objection to the decision: At a time when elected officials are acting to change course, unelected officials are undermining the expression of popular will — demanding balanced budgets — by sticking with the same policies. Since the Fed is supposed to be independent of politics, that charge is not compelling.
A more biting criticism is that the move will stimulate inflation and undermine long-term economic prospects. In fact, the program is intended to create inflation. The Fed fears that inflation is too low and the fear of falling prices is keeping companies from investing and consumers from spending — both wait until tomorrow for a better deal. Fed Chairman Ben Bernanke has warned that very low inflation can lead to long periods of economic stagnation. That has been Japan’s problem since the bursting of the bubble in 1991.
The prospect of injecting more money into the market and rising prices is intended to prod homeowners to refinance mortgages, spur businesses to invest and boost consumer confidence and spending. Not surprisingly, markets have responded well to the move: U.S. stock prices have increased 14 percent in recent weeks as buyers anticipated both the move and its impact. Some economists believe stocks would have climbed higher if the Fed had not been so timid.
There are several dangers, however. The first is that inflation will get out of hand and put long-term economic stability at risk. Given current conditions and the Fed’s sensitivity to the prospect of inflation, that risk is low. A second, more realistic fear is that the Fed’s move will depress the value of the U.S. dollar. This is not a problem for the U.S. — in fact, it is an intended consequence, even if no one in the Fed will admit it — but this is problematic for other exporting countries that compete with U.S. products.
There is real concern that just as tariff barriers defined the Great Depression, competitive devaluations will characterize the Great Recession. Both are beggar-thy-neighbor policies and will spur other governments to similar action. Already, Japan, South Korea and Brazil are taking steps to keep their own currencies from rising. China has long adopted this strategy to keep the value of its currency low and boost its exports.
Equally worrisome is the prospect of cheap U.S. dollars flooding other markets in search of higher returns. Remember: U.S. interest rates are low, so it makes sense to borrow there and then put the money to work in economies that pay higher returns. Again, Japan has experience with this phenomenon: its own ultra-low interest rates spawned the “yen carry trade.” This “hot money” is already swamping some developing economies such as Thailand. They are being forced to adopt currency controls to stem the flood of dollars.
QE2 is a risky strategy, not just for the U.S. but for the world. But the U.S. economy is not yet back on its feet and more substantive measures are required to create a durable recovery, which is essential to world economic growth. While some complain that it unfairly advantages the U.S. and its exports, those steps are required if the rebalancing of the world economy — a precondition of long-term stable growth — is to occur.
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