With voters up in arms about unconscionable federal and state deficits and likely to change the ability of the federal government to add even more “stimulus” in the next Congress, all eyes are now on the Federal Reserve (Fed). QE2 (Quantitative Easing 2 – government speak for money printing) has been promised by various Fed documents and Federal Open Market Committee (FOMC) member public speakers, including Chairman Bernanke himself. The equity markets have responded. Priced in is a large stimulus with the expectation that it will lead to an increase in the anemic rate of economic growth, and, hopefully, a lowering in the rate of unemployment. Any disappointment is likely to have a significant impact on the equity markets.
But, beyond the transitory impact on the equity market, is QE2 good public policy? A good, question, especially since QE1 did not produce any measurable economic growth. Some folks argue that QE1was a success in the sense that it saved the credit markets from complete collapse and likely saved several large financial institutions. However, the issue today isn’t the functioning of those markets. In fact, new debt issues have no trouble finding buyers today. The issue today revolves around an economy that cannot find traction.
So, what does the Fed hope to accomplish by bloating up its already pregnant balance sheet? It is pretty clear that the economy is in a liquidity trap. That is, like the 1930s, the banking system already has an extremely high level of excess reserves and there appears to be no demand for borrowing. On the contrary, because consumers have too much debt, they are now foregoing consumption and borrowing despite historically low interest rates (Mohammed El-Erian’s “New Normal”). Thus, on a monthly basis, we continue to see significant loan contraction. The actual implementation of QE2 (the buying of bonds and notes in the open market) adds reserves to the banking system, and lowers interest rates on the part of the yield curve in which the purchase operations take place, with, perhaps, some trickle down to the rest of the yield curve. Given the level of excess reserves already in the system, the Fed certainly can’t be hoping that these actions will spur loan growth. And, given the already historic lows in interest rates, they can’t be foolish enough to think that the lowering of rates by a few basis points will have a significant impact. Then, what can the Fed possibly be hoping for in this round of money printing?
Another Asset Bubble?
Asset inflation is one possibility. And the announcement of QE2 has been, to date, successful in inflating equity prices. The hope here appears to be that rising equity prices will cause a “wealth effect” – an increase in consumer confidence and more spending because of the perception of rising equity values. All past studies of the “wealth effect” that I am aware of suggest that its impact on consumption is quite small compared to other policy tools. Unfortunately, all of the other tools have already been completely deployed.
QE2 also increases the potential money supply, resulting in rising inflation expectations, and, ultimately resulting in a weakening dollar relative to other currencies. In other blogs, I have discussed the “race to the bottom” in the world’s currencies (see “How the U.S. Should, But Won’t, Handle Job Creation”, Minyanville, 10/6/10). Given the very strong deflationary pressures in housing and from record levels of unemployment, it appears that the Fed hopes to combat such pressures by influencing inflation expectations. Again, the impact here doesn’t appear to be very robust.
Trade Deficit Reduction?
Finally, it seems that the Fed, by its QE2 announcement, must believe that a weaker dollar will improve the trade deficit and ultimately bring jobs back to the U.S. This appears contrary to what Treasury Secretary Geithner says about a strong dollar, but there just isn’t any other possible interpretation. Because other countries react by lowering the value of their currencies to protect their export industries, there doesn’t appear to be any benefit here, either.
Negative for Jobs
There are potential intermediate and long-term negative consequences of QE2. One possible negative impact is on jobs, and is contrary to the objective of the QE2 program. First, many companies have invested in plant and equipment overseas, so their commitment isn’t reversible in the short-term. Second, most companies look for a business environment where they are comfortable, i.e., where there is visibility into the future tax and regulatory environment, something that the U.S. currently lacks. Third, and what isn’t widely recognized, is that a weak dollar policy (QE2) drives dollars (capital) to other countries in the attempt to protect its value. As dollars flow to places with more stable tax and regulatory environments, it is invested there, thus enhancing economic growth there, not here. The dollars that do return to the U.S. are invested in very short-term investments (U.S. Treasury Bills and Notes) which, by their nature, are not invested in long-term projects (i.e., they finance current U.S. government deficits), and, therefore, do not create jobs.
Negative for Consumers
The intermediate and long-term impacts of QE2 is also likely to be negative for consumers. Ever lower interest rates on consumer deposits and along the yield curve continues to remove income from savers and investors and transfers it to the large financial institutions and to the large publicly traded companies. The lower cash throw offs from savings and investments causes lower levels of consumption.
In addition, the weaker dollar, as a result of QE2, has two more negative impacts on consumption:
- A weaker dollar means higher commodity prices in dollar terms (note the rise in the prices of gold, industrial metals, oil, and agricultural commodities since the announcement of QE2) which are inputs in the manufacturing process. If they can, manufacturers will pass along these higher costs to consumers in the form of higher prices. In this case, consumption will be negatively impacted unless consumer incomes rise faster than the prices (not likely with high unemployment levels). In the more likely case that most of the increase in input costs cannot be passed on because of consumer resistance, corporate margins get squeezed. Again, a negative result for economic growth. Furthermore, some of these commodities are more important than others, e.g., oil and food. After 40 years of dependence on foreign oil, we should be well aware of the negative impact on consumption of rising gasoline prices.
- Then, of course, there is the direct impact of a weaker dollar on the prices of imported goods. Despite Walmart’s commitment to lower prices, because they are a huge importer of foreign manufactured goods, as the dollar weakens, even their prices will have to rise.
More Harm than Good!
Most of the large multinational firms can deal with a weaker dollar and new regulations. For them, because they have significant sales in other currencies, a weaker dollar is beneficial to their overall dollar denominated income statements. But small, domestic businesses are another story. In this economy, they cannot pass on increases in their input costs due to a weakening dollar. Furthermore, rising taxes and fees from federal, state, and local governments (e.g., the costs of Obamacare) and added regulations (e.g., new IRS 1099 reporting requirements) are overwhelming small businesses. Small businesses create the vast majority of jobs in the U.S. The weaker dollar implied by QE2 will further impact the already reeling small business sector. There is only one conclusion to be drawn: QE2 is likely to do much more harm than good.
Robert Barone, Ph.D.
October 25, 2010
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