In These New Times

A new paradigm for a post-imperial world

Quantitative easing- cure or kill?

Posted by smeddum on June 12, 2009

Inside investment: Quantitative easing – Kill or cure?
Monday, June 08, 2009
Andrew Capon
Quantitative easing is being hailed as a policy panacea. The problem is that it sounds a lot like a prescription that causes the very problems it is designed to treat.
When the world was a happier place, before economists annexed the lexicon of forensic pathologists, there was much talk about global imbalances. In the final quarter of 2005 the US current account deficit peaked at 6.4% of GDP. Some thought this was a bad thing, although few pinned down exactly why. Others thought it was a “stable disequilibrium”. Export-driven economies, principally in Asia, could in effect provide vendor financing to the US via their high savings rates, foreign exchange reserves and sovereign wealth funds.
We now know that this stable disequilibrium did not beget stability. Instead, it inflated bubbles everywhere. Federal Reserve chairman Ben Bernanke presciently called the rise in current account surpluses in Asia and oil-exporting economies a “global savings glut”. By contrast the US household savings rate as a share of disposable income gradually declined from 10% in the early 1980s and tipped into negative territory in 2003. The reason US savings went negative was that people were using their houses as ATMs. As house prices soared so did equity withdrawal.
Ultimately, like a Ponzi scheme, debt-fuelled demand will collapse under its own weight. Many point to Bernanke’s predecessor at the Fed, Alan Greenspan, as bubble-blower-in-chief. It is now received wisdom that after the TMT bust Greenspan kept interest rates too low for too long. However, Greenspan could only keep rates so low with the complicity of foreign investors, many of them other central banks and official institutions, which were needed to plug the gap in US savings and fund the current account deficit. By 2007 the US absorbed 65% of global capital imports.
Capital was flowing uphill rather than down. By 2006 emerging economies were financing more than 70% of the US deficit. This kept US Treasury yields low regardless of what the Fed did (Greenspan’s conundrum) and mortgage rates plummeted to around 5.5% in 2003. This encouraged new buyers, house-price inflation, more equity release and a consumption splurge. Those new mortgages were in turn securitized. Investors unhappy with low US treasury yields snapped up anything that offered a bit more juice, spawning the toxic alphabet soup of structured credit and a soar-away stock market.
The rest is history. In March the Federal Reserve reported that US household wealth had declined by $12.8 trillion since the peak in September 2007, real-estate wealth declined by $3.6 trillion and investment wealth by $9.2 trillion. Peak to trough, the TMT bust between 2000 and 2002 cost US households $4.2 trillion. Global imbalances and policy missteps following the bursting of one bubble fuelled an even bigger bust a mere seven years down the road.


“Just as one relatively 
unthinking group of buyers 
has seen their influence on 
bond markets start to wane, 
they have been supplanted 
by the dumbest bid of all”

The danger now is that history will repeat itself. Global imbalances have moderated but are still with us. US households are saving once more but the US Treasury needs more money than ever. Issuance of bonds with a maturity of greater than two years will rise from $880 billion in 2008 to $1.2 trillion this year. This equates to 12.7% of GDP. The US is still dependent on the kindness of strangers.

>Recent rhetoric suggests that official institutions will be more discriminating in future. Chinese vice-finance minister Li Yong told the IMF/World Bank Development Committee meeting in Washington in April that a “flawed international monetary system is the institutional root cause of the crisis and a major defect in the current international economic governance structure”.
Other comments from Chinese officials make it plain that the export-driven growth model is itself in the spotlight and that the government will attempt to rebalance the economy towards domestic consumption. Global reserve growth has already begun to moderate for the first time this decade, down from a peak of $7.01 trillion in the second quarter of 2008 to $6.71 trillion, according to the IMF.
However, just as one relatively unthinking group of buyers has seen their influence on bond markets start to wane, they have been supplanted by the dumbest bid of all. The Federal Reserve, Bank of England and other central banks are now busily buying their own bonds in an exercise known as quantitative easing. With interest rates effectively at zero, the intention is to loosen monetary policy further by pushing down longer-term government bond yields and therefore the rates at which companies and individuals can borrow.
The credit crunch forced consumers, investment banks and hedge funds off the heroin of easy credit and bountiful leverage. Now central banks are offering the methadone of QE.
This might be a more humanitarian approach than a period of cold turkey. However, if the side effect is the return of inflation, then the cure may be worse than the ailment. Some economists believe a bout of inflation is necessary, to help the indebted. History suggests that once the inflation genie escapes, taming it will exact a high price.

Andrew Capon is editor-in-chief at State Street Global Markets, the research and trading business of State Street Corp. He was formerly senior editor at Institutional Investor and has won numerous awards for journalism on fund management and investment issues. The views expressed are the author’s own


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