During times of uncertainty banks do not want to lend and consumers do not want to borrow. Increasing liquidity does not necessarily result in increasing demand
All of our great and good leaders like to exercise power. The greatest power is economic power and as such governments are drawn to exercise it by interfering with the markets. They do so, at least ostensibly, for our benefit and often with the best intentions. What they fail to understand is that there are always consequences, most of which are unintended.
The latest and in a sense grandest display of power may soon be revealed by the United States Federal Reserve (the Fed) in the form of quantitative easing. This process requires that the balance sheet of the central bank be expanded through the purchase of long-term assets in an attempt to drive down long-term interest rates. These measures are used when interest rate manipulation is no longer available, because short-term interest rates are already at or close to zero.
The fact that a central bank can use quantitative easing, or as it is popularly known QE2, does not necessarily mean that it works. According to a study by JP Morgan, the purchase of $2 trillion worth of treasury bills might only lower short-term interest rates by 50 basis points. At this time the rumoured proposals for QE2 by the Fed do not suggest utilising anything near that amount of money. In fact QE2 may do nothing at all.
Federal Reserve Governor, Charles Plosser remarked, “Long-term rates have already come down over 100 basis points since the spring and we did nothing. So what makes us think that another 20 basis points is going to make any difference whatsoever?” It is also possible that the United States effort will imitate the experience of Japan where the provisions for yen liquidity simply got stuck in the Japanese banking system. The reason for this is simple. During times of uncertainty banks do not want to lend and consumers do not want to borrow. Increasing liquidity does not necessarily result in increasing demand.
In fact, QE2 could ultimately be exceptionally counterproductive. Investment icon Jeremy Grantham wrote a scathing analysis. “Adhering to a policy of low rates, employing quantitative easing, deliberately stimulating asset prices, ignoring the consequences of bubbles breaking, and displaying a complete refusal to learn from experience has left Fed policy as a large net negative to the production of a healthy, stable economy with strong employment.”
The Fed in attempting to revive the US economy seems to have forgotten that its actions can reach far beyond America’s shores. By forcing down interest rates and the value of the dollar, they have unleashed the mother of all carry trades that is playing havoc across the world. For example, India’s equity and bond market have attracted $33 billion of foreign funds which have sent the Sensex to all-time highs, while long-term foreign direct investment has in fact dropped.
Korea, Japan and South Africa’s currencies have risen dramatically against the dollar but their export industries have been crippled. The flood of foreign funds has pushed Indonesia's dollar bonds to yield just one percentage point above their US equivalent, but this torrent will not last forever. As occurred during the Asian crisis of 1997, the foreign funds could dry up from one moment to the next.
The diplomatic effects of the Fed’s actions may in fact be devastating. Many governments see it as an irresponsible devaluation of the dollar in an attempt by the United States to export America's problems to the markets of Asia and Latin America. Many emerging markets including Brazil, Indonesia, South Korea, Taiwan and Thailand are considering either market intervention or capital controls — neither of which have been very successful.
The United States’ efforts to get China to change its policy regarding the renminbi are being hobbled by the actions of the Fed. In a recent G20 communiqué, issued during the meeting in Korea, America’s trading partners specifically exhorted the United States to be “vigilant against excess volatility and disorderly movements in exchange rates” in order to “mitigate the risk of excessive volatility in capital flows facing some emerging countries”.
Recently there have been some rumours that the Federal Reserve has actually decided that it would be more responsible to be patient and ease in smaller quantities in light of mixed and even optimistic signals from the US economy. If this is true, the markets, which have been discounting a large intervention, might be in for a shock on 3rd November.
The real need is for something that no government, no central bank can supply. John Maynard Keynes coined the expression “animal spirits” when he spoke about speculation, but he also meant the need for trust. The markets can only develop trust when they are sure that government policy remains consistent. In that sense, the unintended consequences of government action like QE2 could easily kill that which it is trying to restore.
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