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The US Federal Reserve is preparing what could turn out to be one of its greatest follies since its defense of the gold standard during the Great Depression. Ben Bernanke, the Fed chairman, has signaled that next month the central bank could begin the process of printing hundreds of billions of dollars to buy US treasuries. The Fed, according to its supporters, wants to bring down medium-term interest rates to speed the national recovery. They cite the danger of deflation, and some may be hoping that a bit of inflation could help address the federal deficit problem. But in fact by some important measures prices are already rising at a speed close to the Fed target.
Since money printing has such a bad name, advocates of such a move are euphemistically calling it "quantitative easing." As if to de-dramatize this monetary explosion and present it as a mere technicality, supporters of the action have even given it the nickname of QE2 (evoking the ocean cruiser Queen Elizabeth II), QE1 being what the Fed did in 2008–09. Despite the reassuring name, this is a very radical measure. It is not needed, and risks many negative consequences for both the United States and the world. Its supporters justify this monetary expansion with three arguments. First, they claim the danger of deflation is great. Second, they want to boost US economic growth. Third, they are concerned about US unemployment being 9.6 percent rather than the maximum of 8 percent predicted in 2009 by Christina Romer, former chair of the Council of Economic Advisers.
None of these arguments holds water, in my view. They are based on macroeconomic models that were not designed for the current abnormal economic situation. Instead of being trapped by these models, we should rely on plausible chains of causes and effects and on elementary logic. The International Monetary Fund is projecting inflation of 1.4 percent this year and 1.0 percent next year, which is just slightly lower than a standard inflation target of 2 percent, and most commodity prices have reached an all-time high, suggesting that inflation is likely to rise.
US growth is anticipated to be around 2.5 percent this year and next. Although many economists worry that this rate may not be enough to reduce unemployment, it would be strange if growth did not suffer after such a horrendous financial crisis, as Carmen Reinhardt and Kenneth Rogoff point out in their monumental work, This Time Is Different. No nation has overcome the business cycle. We have to accept regular periods of recession with negative growth. Yes, there may be a risk of a double-dip recession, but worse things can happen. Finland is experiencing a double dip this year after a GDP fall of 8 percent last year and the Finns' reaction is calm.
The problem is that many Americans think that growth is an entitlement that their government must deliver. It would be cheaper to inform the American public that the business cycle cannot be banished any more than the law of gravity. Populism is understandable during economic crises, but we must not take its recommendations seriously. According to the International Monetary Fund, global economic growth is about to reach 4.8 percent this year, mainly because of the strong surges in the developing world. By global standards, this is a red-hot boom. Global demand is not sufficient but excessive.
Americans are undergoing a crisis of confidence over unemployment, aggravated by an unusually emotional election cycle. Many Americans have suffered in the crisis and lost their homes, but given the massive financial crisis, American unemployment is relatively limited. The whole of Europe has a similar level of unemployment but takes it much more in stride because the unemployed in Europe have a reliable social safety net and universal healthcare insurance.
The United States obviously needs to improve its social safety net, which would not cost much and would also function as an automatic stabilizer, which is more reliable than discretionary projects that carried the whiff of pork. In addition, instead of employing QE2, the government could reduce the payroll tax temporarily. Printing money to reduce unemployment, on the other hand, is like trying to kill a mosquito with a sledgehammer: the certain damage is likely to be much greater than the uncertain benefit. The Fed can act, while the president and Congress are paralyzed, but that is no reason for the Fed to do something so risky.
A problem with the US economic debate is the dominance of macroeconomists, who see all challenges as macroeconomic and not structural. They claim the output gap in the US economy is large. But output gap is a tenuous concept. Post-Soviet Russia had an alleged "output gap" of 70 percent of GDP, and its central bank prescribed unlimited money printing to stimulate demand to reach full capacity. After massive inflation, more insightful policymakers realized that the problems lay not in demand but in supply, which required structural reform.
The United States should accept slower growth as inevitable in a postcrisis period, and instead focus on long-needed structural reforms: improving school education and vocational training, rationalizing the healthcare system, building infrastructure, and undertaking reform of the cumbersome legal system. Admittedly, the United States faces difficulties outside its control, such as China manipulating its exchange rate, but that is only one of many problems, and most US problems should be cured domestically.
We do not actually know whether massive monetary expansion would have any positive effect on the US economy. The simple view of many macroeconomists and their models is that overall US demand will increase with more money and that prices will rise, raising GDP and employment slightly. But this is neither necessary nor likely, because many additional negative effects could occur. The negative impact is also uncertain, but it is likely to be great.
Cheap US financing is already available aplenty for anybody who is creditworthy and wants to invest or consume. Therefore, it is unlikely that more US money in itself will lead to more investment or consumption and thus to more production and employment. A larger volume of money would also debase the US dollar, resulting in a lower exchange rate, as we are already seeing. A lower dollar value may stimulate exports, but the increased volume of money is unlikely to play any positive role. On the contrary, cheap US Fed credits will cause money to flow out of the country into whatever speculative options are open. Capital flows are already whipping around the world, chasing higher returns in gold, metals, and food. Money is also flowing to the remaining countries with well-managed economies, which are largely but not exclusively located in the emerging world, threatening them with asset bubbles of their own.
Fed Chairman Bernanke's announcement about new likely quantitative easing was, by itself, enough to destabilize world currency markets. The dollar plunged, while almost all floating currencies have shot up, many sharply by 30 percent or more. Countries with pegged exchange rates—about half the countries in the world, including China—run the risk of overheating. But another problem is that loose US Fed policy actually causes most free exchange rates to rise more than trade conditions would call for.
The Brazilian finance minister rightly talked about the dangers of a currency war posed by quantitative easing in the United States. The pressure for currency interventions, capital controls, and capital flow taxes is rising even before any Fed action. The ultimate risk is to the stability of the global financial system. Currency mismatches always exist, but aggravating them this way could cause bank crashes. The virtuous countries with well-managed public finances are facing the biggest capital inflows, which cause their exchange rate to become uncompetitive and increase the danger of bubbles. If in response they pursue inflation targeting, they could raise their interest rates—but then their rising exchange rates will make them uncompetitive. If they keep interest rates down, they will suffer from asset bubbles, which are anyhow acute in many emerging economies. This impossible choice will likely provoke trade protectionist pressures. In this fashion, the US Fed may weaken the global trade system as well.
Needless to say, the impending Fed action could also speed the end of the dollar as the dominant reserve currency. Barry Eichengreen has shown that it took half a century for the US dollar to replace the pound sterling as the dominant global reserve currency, but Britain did not pursue any destabilizing monetary policy. The current Fed policy reminds me more of the Bolshevik monetary policy, a classic case of decisive actions and minimal analysis of the secondary effects, leading to the debauching of the ruble. After all, hyperinflation is a modern phenomenon that arose with fiat money after World War I.
There could be other ancillary effects. Poor, developing countries are bracing themselves for riots because of rising food prices, another trend spurred in part by the carry trade of devalued dollars as frightened investors turn to food and other commodities to salvage the value of their money.
Obviously, one positive effect from the Fed massively printing money might be increased exports because of a lower exchange rate. However, currency markets and most economies in the world are likely to be so destabilized that most countries may soon reduce their demand for US goods. This new US Fed expansion may thus be seen even among friends—Europe, Japan, and emerging economies with floating exchange rates—as an act of aggression.
The Fed says it is studying the situation carefully, and there are internal disagreements within its leadership. But it not clear how much analysis has been devoted to the possible consequences of its expected action on the international economy. Nor is it clear that the Fed is consulting American friends and rivals. A failure to consult could damage US credibility in future international economic debates and negotiations.
One place where the pending Fed action must be discussed is within the G-20 and IMF. Indeed, the subject should match Chinese exchange rate manipulation as a matter of urgent concern. Only last July in Toronto, the big topic at the G-20 was the United States suggesting that Germany should adopt a bigger budget deficit, even though Germany already had a public debt of 80 percent of GDP. Provoking this controversy may cause even more havoc.
To sum up, the US Fed, with a policy of renewed QE2, is risking far too much for too little or even nonexistent gains in return.
Anders Åslund is the author of the book The Last Shall Be the First: The East European Financial Crisis.
