Quantitative Easing (Part 3): Why it would NOT work12 October, 2010, 10:56. Posted by Zarathustra
Tags: Quantitative Easing
In the previous part, I discussed the experience of quantitative easing in Japan, which failed to revive the economy and create inflation. Here in the final part, I discuss the reasons why quantitative easing did not, or potentially will not, work.
As I have previously discussed in the article on the aftermath of Asian Financial Crisis in 1997, real estate prices in Hong Kong fell for 6 years. The drop in real estate prices made many people in a situation of negative equity, where their homes are worth less than their outstanding mortgages. Because of the drop in value of collateral and together with the stagnant economy and high unemployment, home owners who still have ability to make mortgage payments would spend less and save more in order to weather the difficult times. Poor consumption demand in turn led to deflation in the next 6 years. The only difference between Hong Kong in 1997 and the United States in 2007 was that the Hong Kong dollar is pegged with US dollar, essentially left Hong Kong no opportunity to tackle this situation with monetary policy. At the bad time in Hong Kong, US economy was booming, USD was strong, and interest rates were rising, hurting Hong Kong economy.
Could monetary policy be the difference? Yes and No, and there are doubts. In his book on Chinese economy, the Chief Economist of World Bank Justin Yifu Li wrote that increasing money supply would not help fighting off deflationary pressure. Here I quote (and translate):
“First of all, no matter how low interest rates are, you have to repay the debt after borrowing. If there is over-capacity in the economy, the motivation for investment is low. Secondly, although consumption should rise if the deposit interest rates are low, under deflationary environment, the employment market is troubled and security of household income is not guaranteed, so that the ability to spend would be constrained even low interest rates should compel people to spend more. In such situation, lowering interest rates cannot stimulate both investment and consumption. In deflationary environment, monetary policy is effectively useless” – Justin Yifu Lin, “On China’s Economy”
(I am not aware of the existence of English translation of this book, if there is, please kindly inform me so that I can put a link here).
Although the situation of the United States might not be exactly the same as Japan or Hong Kong, this quote offers us a glimpse on what might happen with more quantitative easing, and that is there might well be nothing happened.
Of course, to say that nothing will happen is certainly an exaggeration, but I am not entirely sure that the effects of quantitative easing, planned and/or unexpected, are wholly desirable. Yes, there will be increased in monetary base, but the problem is, given the current economic situation where people are probably cautious about the return they can get from investing, more money will not necessarily means more inflation because the newly created money will sit there in the banks’ reserve and not being lent, thus even though the monetary base is creased, the broader money supply measures may not increase.
The weakening of US dollar due to the increased bets on QE2 has led to flood of liquidity all over the world. While the United States is struggling with the recovery of the housing market, Asian real estates have all been rising for the past 1 year and 3 quarters. Gold has been challenging its record high, and stocks market are doing extremely well in September. Indeed what we see is not a true recovery of the real economy. What we are seeing is a smoke screen of false prosperity in the capital markets and Asian real estate markets covering up the true state of the economy.
Ben Bernanke certainly thinks that he is not running out of ammunition, but given the independence of its central bank, he cannot urge the government to increase spending and raise more debt while the Fed will print money and finance the government deficit, not to mention the mounting political pressure to cut spending and deficits. Thus far, we see the Fed acting alone, and it will most probably fail. What will happen in 5 to 10 years down the road?
If the US economy indeed cannot come out of the deflationary pressure, what we will see in the future is not weakening of US dollar due to increased money supply, but appreciation of the US dollar due to relative purchasing power parity, just like the oddly rising Japanese Yen. What we will see is not gold price at $10,000 per ounce, but bubble burst in gold, commodities, equities, and Asian real estate. What we see is not prosperity, but another great financial crisis.