Regular readers will know that I am confident that QE3 is on the way sometime after markets get their swoon on. There are a number of reasons why I’ve formed that judgement. First, it’s because, in my view, the US economy is driven by markets, not the other way around. As Alan Greenspan argued in 2009:
The rise in global stock prices from early March to mid-June is arguably the primary cause of the surprising positive turn in the economic environment. The $12,000bn of newly created corporate equity value has added significantly to the capital buffer that supports the debt issued by financial and non-financial companies. Corporate debt, as a consequence, has been upgraded and yields have fallen. Previously capital-strapped companies have been able to raise considerable debt and equity in recent months. Market fears of bank insolvency, particularly, have been assuaged.
… I recognise that I accord a much larger economic role to equity prices than is the conventional wisdom. From my perspective, they are not merely an important leading indicator of global business activity, but a major contributor to that activity, operating primarily through balance sheets. My hypothesis will be tested in the year ahead. If shares fall back to their early spring lows or worse, I would expect the “green shoots” spotted in recent weeks to wither.
In November 2011, Ben Bernanke echoed these sentiments when explaining the rationale for QE2:
With short-term interest rates already about as low as they can go, the FOMC agreed to deliver that support by purchasing additional longer-term securities, as it did in 2008 and 2009. The FOMC intends to buy an additional $600 billion of longer-term Treasury securities by mid-2011 and will continue to reinvest repayments of principal on its holdings of securities, as it has been doing since August.
This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.
So, we seem to have a Federal Reserve that is unchanged in its views: that is, that when equity prices fall so too does economic activity. Hence my conclusion that as equity prices drop coming out of QE2 we can pretty much expect another round of monetary stimulus.
The second reason I’m of that view is the assumption that the US will struggle to renew fiscal stimulus, even though that is the better option in their circumstances.
However, we can’t simply accept this as a done deal. There is clearly a mighty idealogical and political struggle underway in the US and several important recent articles in the world’s media that suggest that fiscal stimulus may be possible ahead of the ‘goosing of the stock market’ approach to monetary policy. For instance, today there is very important piece by Larry Summers in the FT in which outlines the shortcomings of the ‘goose the stockmarket’ approach:
Inflation dynamics defined the traditional postwar US business cycle. Recoveries continued and sometimes even accelerated until they were murdered by the Federal Reserve with inflation control as the motive. After inflation slowed, rapid recovery propelled by dramatic reductions in interest rates and a backlog of deferred investment, was almost inevitable.
Our current situation is very different. With more prudent monetary policies, expansions are no longer cut short by rising inflation and the Fed hitting the brakes. All three expansions since Paul Volcker as Fed chairman brought inflation back under control in the 1980s have run long. They end after a period of overconfidence drives the prices of capital assets too high and the apparent increases in wealth give rise to excessive borrowing, lending and spending.
Our current situation is very different. With more prudent monetary policies, expansions are no longer cut short by rising inflation and the Fed hitting the brakes. All three expansions since Paul Volcker as Fed chairman brought inflation back under control in the 1980s have run long. They end after a period of overconfidence drives the prices of capital assets too high and the apparent increases in wealth give rise to excessive borrowing, lending and spending.
Larry Summers was one of the key architects of the post-modern US economy and its dependence upon financial market-driven growth. It was he, with Robert Rubin and Alan Greenspan, that helped dismantle much of the financial regulation that had been in place in the US since the Great Depression reforms of FDR’s New Deal. Whilst Summers is certainly not recanting those ideals, he is explicitly calling time on the asset-driven growth model that resulted. By recognising that the US has a demand shortage, he is also, intrisically, acknowledgeing the decline of the American middle class. He almost says as much:
Beyond the lack of jobs and incomes, an economy producing below its potential for a prolonged interval sacrifices its future. To an extent once unimaginable, new college graduates are moving back in with their parents. Strapped school districts across the country are cutting out advanced courses in maths and science. Reduced income and tax collections are the most critical cause of unacceptable budget deficits now and in the future.
Summers concludes that:
The fiscal debate must accept that the greatest threat to our creditworthiness is a sustained period of slow growth. Discussions about medium-term austerity need to be coupled with a focus on near-term growth. Without the payroll tax cuts and unemployment insurance negotiated last autumn we might now be looking at the possibility of a double dip. Substantial withdrawal of fiscal stimulus at the end of 2011 would be premature.
…At the same time we should recognise that it is a false economy to defer infrastructure maintenance and replacement, and take advantage of a moment when 10-year interest rates are below 3 per cent and construction unemployment approaches 20 per cent to expand infrastructure investment.
Obviously Summers’ comments should be seen in the context of the current political wrangle in the US over the debt-ceiling and the Budget deficit. But coming from Larry Summers, the former champion of fiscal restraint, derivatives and financial market-led growth they seem more profound than that. Fact is, Summers sounds an awful lot like Paul Krugman, who wrote last week that:
Back when the original 2009 Obama stimulus was enacted, some of us warned that it was both too small and too short-lived. In particular, the effects of the stimulus would start fading out in 2010 — and given the fact that financial crises are usually followed by prolonged slumps, it was unlikely that the economy would have a vigorous self-sustaining recovery under way by then.
By the beginning of 2010, it was already obvious that these concerns had been justified. Yet somehow an overwhelming consensus emerged among policy makers and pundits that nothing more should be done to create jobs, that, on the contrary, there should be a turn toward fiscal austerity.
…So, here we are, in the middle of 2011. How are things going?
…As the stimulus has faded out, so have hopes of strong economic recovery. Yes, there has been some job creation — but at a pace barely keeping up with population growth. The percentage of American adults with jobs, which plunged between 2007 and 2009, has barely budged since then. And the latest numbers suggest that even this modest, inadequate job growth is sputtering out.
So, is the worm turning back towards fiscal stimulus? Finally, let’s refer to Ben Bernanke’s most recent speech:
The prospect of increasing fiscal drag on the recovery highlights one of the many difficult tradeoffs faced by fiscal policymakers: If the nation is to have a healthy economic future, policymakers urgently need to put the federal government’s finances on a sustainable trajectory. But, on the other hand, a sharp fiscal consolidation focused on the very near term could be self-defeating if it were to undercut the still-fragile recovery. The solution to this dilemma, I believe, lies in recognizing that our nation’s fiscal problems are inherently long-term in nature. Consequently, the appropriate response is to move quickly to enact a credible, long-term plan for fiscal consolidation. By taking decisions today that lead to fiscal consolidation over a longer horizon, policymakers can avoid a sudden fiscal contraction that could put the recovery at risk. At the same time, establishing a credible plan for reducing future deficits now would not only enhance economic performance in the long run, but could also yield near-term benefits by leading to lower long-term interest rates and increased consumer and business confidence.
Hmmm…not a lot of daylight there for expanding the Budget, although a short term plan to boost demand, if coupled with a long term plan for consolidation, might fit Bernanke’s needs.
