World Economy: Quantitative Easing

‘Plan B’ – Will it work?

In a desperate move to boost US growth, the Federal Reserve has launched QE2, a second round of quantitative easing. Its main effect will be to devalue the dollar, an attempt to boost its exports at the expense of its rivals, particularly China. This unilateral action by US imperialism can only intensify the currency wars and trade conflicts.

World Capitalism avoided a deep slump on the scale of 1929-33 through a combination of economic stimulus, bank bailouts and quantitative easing (the pumping of cheap liquidity into the system) carried out by the G20 states. The advanced capitalist countries were more severely affected by the ‘great recession’ than the semi-developed countries, which were partly sustained by the demand for raw materials from China, which continued to grow at around 9% a year. Global GDP growth began to revive in the second half of 2009 and the beginning of 2010. This, however, has been accompanied by mass, structural unemployment and a savage attack on working-class living standards.

From the spring of this year, however, the fragile, uneven recovery began to falter. This was for a number of reasons, including the slowdown of the US economy. The sovereign debt crisis which opened up earlier in the year, particularly affecting the peripheral eurozone countries, had a negative effect on business activity. Economic stimulus packages in the US and Europe began to fade away. Moreover, a number of major economies, notably Britain and Germany, turned away from fiscal stimulus to ‘fiscal consolidation’, a policy of the drastic reduction of state deficits over a short period of two to four years.

The US economy, in particular, began to slow down in the second half of this year. After July 2009, the US economy began to grow at an annualised rate of around 3%, but by the second quarter of 2010 growth had fallen to an annualised rate of 1.6%. It increased slightly to 2% in the third quarter, but this was mainly on the basis of businesses rebuilding their inventories (stocks of goods for sale, etc), which is most likely a temporary effect that will fade away at the end of this year.

The Obama administration undoubtedly wanted to introduce a second economic stimulus package this year, but was deterred by both opposition in Congress and massive public hostility to what are seen as outrageous handouts to the banks and big business. The approach of the midterm elections at the beginning of November ruled out another package. Since that time, the strengthened Republicans have mounted a clamour of opposition against renewed stimulus measures or even another round of quantitative easing. However, with major economic initiatives stymied politically, a new round of quantitative easing carried out by the Federal Reserve, which has a degree of independence from Congress and the administration, was left as the only available option. Having argued the case for another round of ‘credit easing’, Ben Bernanke launched QE2 the day after the midterm elections – promising to inject more than $600 billion of ultra-cheap credit into the banking system. This is a desperate attempt to revive growth in the US economy, which will have a profoundly destabilising effect on the global economy.

Deflation or inflation?

QE2 is really a poor substitute for another economic stimulus package. But ‘stimulus’ had become confused with ‘bailout’, which was seen as a massive handout to the banks and finance companies at the expense of taxpayers. While millions of workers and middle-class people have faced unemployment and foreclosures, Wall Street returned to profitability. The securities industry was hit by losses of $42.6 billion in 2008, but raked in $55 billion profits in 2009. They paid out a record $20.3 billion in bonuses. Obama’s treasury secretary, Timothy Geithner, admitted earlier this year: “We saved the economy but we kind of lost the public doing it”.

Apart from persistent, long-term, structural unemployment, the Obama administration and the Fed also fear the slide into deflation, raising the spectre of Japan in the 1990s and since. In the twelve months to October, the overall inflation in US consumer prices was 1.2%, while core inflation (excluding food and energy) rose just 0.6%. This is the lowest level of core inflation since the 1961 recession. Deflation is a drag on growth because it makes debt more expensive (raising real interest rates) and leads consumers to postpone purchases in the expectation that prices will be lower at a later date.

But will another round of QE have a significant effect on US growth? The first round undoubtedly eased the credit squeeze, but operated together with the bank bailout and the economic stimulus programme. Ultra-cheap credit for the banks, however, did not lead to a big upsurge in bank lending to small and medium businesses, or home buyers or consumers. Had the additional credit been channelled to workers and middle-class people, it might have had a significant effect in stimulating demand and lifting the rate of growth. Most of the extra liquidity, however, was channelled abroad in speculative activity by the banks, hedge funds, and wealthy speculators. At the same time, the major banks are currently sitting on $1 trillion of ‘excess’ capital reserves (that is, reserves over and above what they are legally required to hold against possible losses).

The forces of deflation will remain strong despite QE2. There is a massive debt burden, with millions of foreclosures and distressed mortgages. There are still a huge number of unoccupied houses, and house prices are still falling. There is a mountain of credit-card debt, with interest rates on consumer credit way above the Federal Reserve’s base rate. Above all, unemployment is a drag on the economy. Despite the limited ‘recovery’ of GDP growth, unemployment in September 2010 remained officially at 9.6% of the workforce. This did not include eleven million who had stopped looking for work or who had been forced to accept part-time employment. Adding these people to the figures, the US September rate of under-employment was 17.1%, about one in six of the workforce.

Unless there is a revival of demand, businesses will not invest in new plant and equipment, or even sustain their current levels of production. QE2 could provide more cheap credit to business, but in itself will not restore profitability. Without demand – as John Maynard Keynes put it – extra credit creation is merely “pushing on string”.

Strengthened by the midterm elections, Republicans lost no time in denouncing the launch of Bernanke’s QE2. They have accused Bernanke of paving the way for “currency debasement and inflation”. These advocates of ultra-free market policies consider the economy should be left to take its own course, regardless of the consequences for the working class and middle-class people. Bernanke and other Fed leaders have been forced to hit back at their critics, but (it has now emerged) they originally considered much bigger credit-creation measures but pulled back under the barrage of criticism, settling for the relatively modest $600 billion QE.

Do the accusations of the free-marketeers have any validity? With regard to the dollar, QE2 will undoubtedly lead to a major devaluation. This is, in fact, one of the main aims of the policy, to stimulate growth through boosting exports. Inflation, however, is not an immediate danger for the US – let alone the Weimar-type hyper-inflation predicted by some ultra-rightwing ideologues.

If all the additional credit created by QE2 were spread throughout the US economy it might well have the effect of stimulating price increases as demand tended to outrun the supply of goods and services. In fact, on the basis of past performance, most of the additional credit will actually be deployed in speculative investment abroad, particularly in so-called ‘emerging markets’, the semi-developed economies of Brazil, Asia and so on. This trend, it is true, is likely to stimulate inflation in those countries, thus exporting inflation from the US. In time, the increased dollar price of imported commodities and manufactured goods will have some effect on domestic prices. But at the moment the forces of deflation within the US are still strong, with weak demand (because of unemployment, reduced incomes, and the huge debt burden) and huge overcapacity in the manufacturing, house-building and service sectors. All this puts downward pressure on prices.

In the longer term, however, quantitative easing could lead to an acceleration of inflation. At the moment, the Federal Reserve is trying to promote inflation of around 2%, which it calculates would lighten the burden of debt (through lowering the real interest rate) and allowing small- and medium-sized businesses to raise their prices (with wages lagging behind prices) and improve profitability. The more far-sighted bourgeois strategists positively want a higher rate of inflation, of at least 2% or even 4% for a period. Economists like Krugman and Stiglitz see this as essential to escape the ‘debt trap’ and stimulate sustained growth.

Later, if GDP growth begins to accelerate then inflation could also begin to accelerate even more. The Fed’s plan would then be to take back some of the liquidity previously pumped into the economy, through raising interest rates and selling securities (government bonds, company bonds, etc) now held by the Fed. But even Bernanke admits that this is an untested and risky policy. Today, the strategists of capitalism fear deflation, but further down the road they will once again face the perils of inflation (their bête noir in the 1970s). Increased gold purchases by the wealthy pushed the price of gold (in current dollars) to a record high in early November (though in inflation-adjusted terms it is 40% below its 1980 peak).

A speculative binge

Officially, the aim of QE2 is to stimulate growth in the US economy through a new injection of cheap credit. Few people, however, even at the Fed, believe this will have a dramatic effect on the home economy. The main – unacknowledged – aim is to devalue the dollar, lifting US growth through a growth of exports. US leaders will deny this. Financiers, however, are more realistic. “Devaluation is the intention, devaluation is what is going to happen”, commented the chairman of Elara Capital, a major foreign exchange trader.

The first round of QE has already brought about a massive devaluation of the dollar (around 20% from its peak level). This is because most of the additional liquidity has been used for speculation in overseas markets rather than investment in the US. There has been a huge growth in the dollar ‘carry trade’, which involves financiers, speculators and big corporations (sitting on piles of cash) borrowing cheap dollars and investing them in countries with stronger currencies and higher interest rates. This has brought a new bubble in so-called ‘emerging markets’, semi-developed economies like Brazil, India, Indonesia, etc. There has also been increased investment in commodities, including food, which has pushed up world prices over recent months. Despite the availability of ultra-cheap credit at home, big business does not see big possibilities of profitable investment within the US, and therefore prefers to speculate internationally. But the new bubbles being blown with cheap QE credit will inevitably burst, provoking new crises in the semi-developed economies that appeared to escape the worst effects of the 2008-09 downswing.

The flow of funds out of the dollar and into other currencies depresses the value of the dollar and lifts the value of target currencies. While improving the competitive position of US exports, this process renders exports from countries with rising currencies less competitive. In recent months, Brazil and other states have intervened on foreign-exchange markets to try to limit the rise of their currencies. But, given the huge daily turnover on foreign exchanges, this has become increasingly difficult, despite the big foreign-currency reserves held by many of these countries (‘self-insurance’ adopted after the 1997 Asian currency crisis).

China, however, is in a different position, as the Chinese regime has pegged its currency, the yuan or rmb, to the US dollar. The regime has allowed a marginal (3-4%) revaluation of the yuan against the dollar since June, but refuses to allow the substantial (20-40%) revaluation demanded by the US and other advanced capitalist countries. Such a huge realignment would undoubtedly undermine China’s exports, threatening a slowdown of the Chinese economy, with the possibility of social instability and explosive movements of Chinese workers and small farmers.

US leaders have ever more stridently been accusing China of ‘currency manipulation’ because it rejects a substantial revaluation of the yuan. However, QE2 is undoubtedly a massive exercise in currency manipulation. This was bluntly spelled out recently by the German finance minister, Wolfgang Schäuble: “It is not consistent when the Americans accuse the Chinese of exchange rate manipulation and then steer the dollar exchange rate artificially lower with the help of their [central bank’s] printing press”. (Financial Times, 7 November)

QE2 will undoubtedly intensify the ‘currency war’ which was the main issue at the Seoul G20 summit, where there was no agreement on measures to curb surplus/deficit imbalances or currency movements. A number of semi-developed countries have already adopted capital controls in an effort to reduce speculative flows of money, and QE2 undoubtedly increases the likelihood of outright protectionist measures being adopted.

Bleak outlook for world capitalism

The latest forecasts from the OECD (18 November) suggest that the 33 OECD countries (dominated by the advanced capitalist economies) will grow by 2.7% this year, and (they predict) 2.3% in 2011. World growth, however, will be 4.6% and an estimated 4.2% next year. The main factor in the higher level of world growth (compared to the OECD group) is the growth in China, which has been sustained by a massive economic stimulus package. China has created demand for energy, raw materials and producer goods from countries such as Japan, Germany, Brazil, Australia, etc.

Following a ‘great recession’, which could have been much worse than it was, these growth figures appear quite substantial. However, GDP growth is not the whole story. In the advanced capitalist countries, in particular, this weak recovery has been accompanied by prolonged mass unemployment, the erosion of workers’ living standards and an assault on social spending.

The strategists of capitalism recognise that the recovery, such as it is, has not resolved any of the underlying problems in the world economy. Moreover, events and renewed episodes of crisis could at any time cut across this recovery.

In the advanced capitalist countries and some of the weaker, peripheral economies of eastern Europe, the huge debts accumulated by the finance sector in the pre-crisis boom have been transferred to the state, with the burden of repayment being passed on to the working class. This has effectively added to the enormous debt burden already accumulated on the basis of a credit-fuelled housing boom and credit-based consumer spending.

Fiscal stimulus has been largely replaced by fiscal consolidation. The Keynesian wing of the capitalist class has argued that state debts should be paid off more gradually as the economies begin to go into sustained growth. They believe that the governments now implementing savage spending cuts and tax rises are repeating the mistake of Roosevelt in the US in 1936-37 when he reversed many of the New Deal programmes, pushing the US back into recession (only reversed again by the onset of the second world war). However, a combination of the enormous international pressure of financial markets and the ultra-free market ideology of a big section of big-business leaders and bourgeois politicians has allowed the ‘consolidators’ to prevail. There is undoubtedly the possibility that spending cuts on a massive scale will actually induce new downturns in many countries, leading to an increase rather than a decrease of state deficits.

The Irish government has now (21 November) agreed a €90 billion rescue package with the IMF, ECB and the British government, in order to prevent a collapse of the Irish banking system. However, it is far from certain that this ‘solution’ will hold together. The spectre of default (‘rescheduling’ of debt) still looms over Ireland, Portugal, Italy and Spain. A European-wide banking crisis cannot yet be ruled out, and such a crisis would undoubtedly cut across the growth in the world economy.

The limited recovery since last year, moreover, has in no way overcome the major imbalances in the world economy. The contradiction between the deficit countries (notably the US) and the surplus countries (China, Japan, Germany, etc) has not been in any way overcome. These imbalances are the basis of the currency wars now unfolding, which could spill over into open trade war.

The G20 meeting in Seoul completely failed to reach agreement on the most pressing issues facing the world economy, particularly the questions of deficits and currency alignments. There is no ‘coordination’ between the major economic powers. The USA’s QE2 is a unilateral act of competitive devaluation. It is a direct challenge to the Chinese regime and will have a profoundly disruptive effect on the world money system and trading relations.

Even before Bernanke announced the new credit-easing measure, China’s central bank announced that it was requiring China’s commercial banks to increase the reserves they have to deposit in China’s central bank (from 17.5 to 18% of their capital). This is intended to dampen growth, to counter the recent acceleration of inflation. The alternative policy of raising interest rates would have had the disadvantage for China of attracting more speculative capital into the country. On the other hand, the reserve requirements (deposited on the basis of very low interest rates for the banks concerned) provides the funds necessary for the Chinese government to intervene on foreign-exchange markets, buying foreign currency and holding down the level of the yuan/rmb.

Despite the OECD’s relatively optimistic forecast for the world economy, there could still be a relapse into a new recession in the short term. On the other hand, there may be a period of several years of low, erratic growth. That, in turn, could give way to a new downturn in the not-too-distant future.


What is QE?

The main policy tool of central banks has usually been the variation of interest rates. Lowering short-term rates (making credit cheaper), under normal conditions, stimulates growth. Raising rates dampens growth, and has normally been used to reduce ‘overheating’ (rapid growth of output putting pressure on the supply of materials and producer goods, thus leading to inflation). Manipulation of interest rates is the ‘conventional’ policy tool.

But when banks become reluctant to lend, however cheap credit may be, lowering rates no longer has a stimulating effect on the economy. In any case, rates cannot go below zero. (That is, nominal rates cannot fall below zero: if the rate of inflation is higher than the nominal interest rate, then the real [price-adjusted] interest rate will be negative. Clearly, this does not apply when there is disinflation [a slowing in the rate of price increases] or outright deflation [falling prices]). When rates effectively reach zero, as they have done recently in the US, the only option for central banks (apart from sitting on their hands) is the use of ‘unorthodox’ tools, such as quantitative easing (QE).

The term ‘quantitative easing’ was first used in Japan in the early 1990s, and has become common currency. Bernanke prefers to use the term ‘credit easing’.

QE is the equivalent of printing money, though today there is no need to actually print new notes. The central bank (the Fed, BoE, BOJ, etc) electronically credits itself with a quantity of money, out of nothing. The bank can then use these new funds to buy government bonds and other securities (mortgage-based bonds, company bonds, etc) either directly from the government or in the secondary market, which is, from the banks and other institutions and investors currently holding them.

Having sold some of their securities to the central bank, banks and investors then have a quantity of cash in their hands that they can use to lend out or invest. The idea is that QE pumps additional credit into the economy, thus stimulating business activity and a higher rate of growth. At the same time, the increased demand for government bonds (from the Fed’s QE purchases) keeps down the long-term interest rate. This reduces the cost of government borrowing, thus enabling the government to finance its deficit.

Unorthodox methods were adopted by the Bank of Japan after the bursting of the property bubble in 1991, which resulted in a seizing up of the credit system and serious price deflation. However, most of the extra yen liquidity got stuck in the banking system, as banks wrote off bad loans and hoarded cash. QE in Japan has not overcome the stagnation of the economy or the tendency to deflation, though it is possible that things would have been worse without it.

In the US, in November 2008, after the implosion of the banking system, Bernanke outlined a range of unorthodox measures that could be used to stimulate growth when the federal funds rate had dropped virtually to zero. Bernanke eschewed the term ‘quantitative easing’, but proposed that the Fed could (create credit to) buy (US government) treasury bonds, mortgage-backed securities issued by Fannie Mae and Freddie Mac, and commercial debt issued by private companies and consumer lenders.

In December 2008, Bernanke cut short-term rates to virtually zero. Then the first round of QE began in 2009. The immediate aim was to counter the almost complete seizing up of credit following the banking crisis and the collapse of the shadow banking sector. By April 2010, the Federal Reserve had purchased $1.7 trillion of treasury bonds and mortgage-backed securities.

The first round of QE undoubtedly eased the severe credit squeeze that developed after September 2008 (and proved highly profitable for the banks, which used the fresh flow of almost zero-cost liquidity from the Fed to invest in profitable assets). In combination with the $700 billion bank bailout (TARP) and Obama’s $787 billion economic stimulus package, QE helped US capitalism to avoid a catastrophic slump on the scale of 1929-33. However, there has been only a very weak recovery in the US (and other major advanced capitalist countries), with the persistence of high levels of unemployment (officially, almost 10%, more realistically, almost 20%) and part-time and temporary working.

On the day after the midterm elections, Bernanke announced that the Fed would buy another $600 billion of treasury bonds and other securities by June next year. The Fed will also be reinvesting around $300 billion from maturing assets that it already holds. The total of securities the Fed now holds on its balance sheet is $2.3 trillion – this is the measure of the scale of the additional credit it has pumped into the economy since 2008.

In 2008, other central banks adopted the policy of quantitative easing. The ECB reluctantly created additional credit but has now ended its purchases of government bonds in the eurozone. The Bank of England has indicated that it is prepared, if necessary, to launch its own QE2, but so far has not done so.

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November 2010