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Will QE2 sail...or sink?

A second round of quantitative easing in the US economy is not required, probably won't work, and may prove counter-productive.

 

Past weeks have seen the US (and world) financial media aflutter with talk that the US Federal Reserve will initiate a second round of Quantitative Easing (QE) aimed at boosting economic growth. This QE2 is generally expected to consist of open market operations such as purchasing financial assets - government bonds, mortgage-backed securities and corporate bonds. QE2 will be a bad idea.

 

Why would QE2 be a bad idea?

  • QE2 will weaken the dollar and hence raise oil prices (which are denominated in dollars). Costlier oil will act as a drag on growth. The Fed believes that the positive effects of a weaker dollar (such as cheaper exports) will outweigh negative effects, but this belief is not sufficiently grounded in empirical experience. 
  • Economists don't know enough about how QE affects inflation; such a policy may well cause inflation to surge
  • Easy funds arising out of QE2 will chase higher returns outside the US; the wall of liquidity already descending on emerging markets in the past few months is thus likely to grow even bigger. This will not only cause QE2's effects to leak out of the US economy, but will also lead to asset price bubbles in emerging markets. QE2 may well thus cause the US to export financial instability to the emerging world.
  • The biggest reason why QE2 will be a bad idea, however, is that there just isn't enough evidence to show that such a policy would work. Prior uses of QE include Japan during the early 2000s and the financial stimulus used in the US and Eurozone in the aftermath of the 2008-09 crisis (i.e., QE1). The Japanese experience was hardly edifying, failing to achieve either higher growth or deliverance from chronic deflation. In any case any extrapolation from Japan to the US would be inappropriate - the US is a far larger economy (almost 3 times the size of Japan), and is a far more diversified, open and vibrant economy, with a currency that is also the world's reserve currency.
 
Of course, it may be argued that QE1 should have been stopped owing to similar misgivings. However the situation was very different then, with most experts believing that economic armageddon was looming. It was a desperate measure, but the desparate situation called for it. And QE1 perhaps did work, at least in some measure (although there are many divergent opinions on this). Things are very different now. The US (and world) economies have been on the mend since the recession officially ended in June 2009 , and the dreaded "double dip" has receded to not much more than a theoretical possibility. As outlined above, quantitative easing in the current situation may well prove ineffective or even a setback. Today, the risks of further easing outweigh any possible benefits.

Prolonged easy monetary policy (in the US and elsewhere) in the aftermath of the early 2000s recession sowed the seeds of the 2008-09 financial crisis; easing monetary policy now may well sow the seeds of the next crisis.
 
 

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