Tuesday, October 26, 2010

Joseph Stiglitz On Quantitative Easing 2

Nobel Laureate and Columbia University liberal economist Joseph Stiglitz wrote a fairly scathing editorial concerning QE2. He begins his piece thus,

"The Federal Reserve, having done so much to create the problems in which the economy is now mired, having mistakenly thought that even after the housing bubble burst the problems were contained, and having underestimated the severity of the problem, now wants to make a contribution to preventing the economy from sinking into a Japanese-style malaise. How? As Chairman Ben Bernanke announced last week, through large-scale purchases of U.S. Treasurys—called quantitative easing, or QE."

Stiglitz then lists three problems he sees with QE2:

"The problem is that, with interest rates already near zero, there is little the Fed can do to restart the economy—and doing the wrong thing can do considerable damage. In 2001, (then) record-low interest rates didn't reignite investment in plant and equipment. They did, however, replace the tech bubble with an even more dangerous housing bubble. We are now dealing with the legacy of that bubble, with excess capacity in real estate and excess leverage in households.

Yet even if the banks were willing and able to lend, lending to SMEs is typically collateral-based, and the value of the most common form of collateral, real estate, has fallen 30% to 40%. No wonder then that credit availability is so constrained. But QE in the form of buying U.S. Treasurys is not likely to affect this much. It will have some effect in lowering mortgage rates, and lower mortgage rates will put a little more money into people's pockets. Higher real-estate prices may also allow some SMEs to borrow more. But these effects, though positive, are likely to be small—so small as to make a barely perceptible difference in America's persistent unemployment.

There is another downside risk: QE may not even succeed in lowering interest rates, or lowering them very much. Given the magnitude of excess capacity, there is little risk of inflation today. But if the inflation hawks come to believe that the risk of future inflation is real, then they'll believe that short-term interest rates will rise. This will mean that long-term interest rates, even now, may actually rise, in spite of the massive Fed intervention, because long-term interest rates are based on expectations of future short-term interest rates.

QE poses a third risk: The bursting of the bond market bubble that the Fed is seeking to develop—the sequel to the tech and housing bubbles—will clearly have adverse effects on the economy, as we should have learned by now."

Stiglitz seems quite complete in his cataloging the problems with QE2 will do. It can't really ignite economic growth, due to the so-called liquidity trap. It won't help the small- and medium-sized US businesses (SMEs), which have more need than large firms for financing. And it may cause a bubble in one of the last unbubbled parts of the financial sector- fixed income. And, he notes, it continues the international currency devaluation competition which can easily hurt the US more than it helps us.

He concludes with a brief restatement of his argument,

"The upside of QE is limited. The money simply won't go to where it's needed, and the wealth effects are too small. The downside is a risk of global volatility, a currency war, and a global financial market that is increasingly fragmented and distorted. If the U.S. wins the battle of competitive devaluation, it may prove to be a pyrrhic victory, as our gains come at the expense of others—including those to whom we hope to export."

I think his last point is extremely valid and largely ignored by the US Treasury and the Fed. Yet it's the one which anyone with a sense of economic history knows contributed greatly to the US economic damage during the Great Depression.

We'd better hope Stiglitz is wrong, but I doubt he is.

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