By Ankit Mital
A few days ago the U.S. Federal Reserve chairman Ben Bernanke announced a new spurt of quantitative easing aka QE2 to be undertaken by the US fed in June 2011. The intention is to increase money supply, i.e. infuse more liquidity in the system, which should drive up asset prices and consequently boost the fledgling consumer spending to help the economy emerge out of the recession.
How does it work? The Central bank prints money and uses it to buy government, corporate or asset backed securities, which simultaneously drives up their prices, infuses money into economy while increasing the excess reserves of the commercial bank, hence increasing lending activity. This creation of liquidity leads to a situation where there is excess money in the economy looking for investment opportunities driving up asset prices while lowering yields (interest rates, hence making credit cheaper). This theoretically increases the wealth of an individual and thus induces him/her to spend more via wealth effect. At the onset of the current recession, QE1 was undertaken by the Central Banks of the US, the UK and Japan followed soon by the European Central Bank. The aim at that moment was different though. Then, the immediate impact of the recession was thee sucking out of liquidity from the system and QE1 was intended to create liquidity and bring down interest rates. Though these objectives were achieved, the Policy makers and economists are still divided over its benefits to the economy. While the Monetarists believe that fixing the money supply is the panacea of all economic problems, there are other schools of thought who believe that such measures are futile, inflationary and have no impact on the real economy whatsoever. Especially in the post recessionary environment where interest rates are already close to zero, how much credit creation would such measures lead to is doubtful.
The buying of government debt at this scale by central banks is nothing but monetization of Government Debt, which only causes inflation. This hurts pensioners, savers, lenders and those on fixed incomes. The measures might have had some benefit if the banks did not have money to lend. That is not the case right now. The real problem is the high risk economic environment which is not conducive to lending with banks having turned risk averse after having their hands burnt in the current recession.
What the QE has done is, is the creation of a bubble in the asset markets. With cash available dirt cheap, investment banks are channelizing this liquidity into speculative activity. The gold and silver bullion shot up by around 30% and 80% respectively in the last year. Stock markets too have witnessed a rally throughout the year, in disproportion to the economic recovery or the lack of it. Food prices are rocketing all over the world, hurting the Emerging economies especially where food inflation is raising its ugly head. If the intention of Ben Bernanke is to create another bubble, well he has succeeded. But how does it bode for the economy. The lessons into what created the current crisis do not seem to have been learnt. The credit crises came about by the bursting of an asset bubble in the US real estate market. In fact, whether it was the Great Crash of 1929 or the dot com bubble of 2001, all were caused by inflated asset markets. Given the current situation in the asset markets, is another crisis lurking in the corner?
The anthem of the East London football club West Ham United, “I'm Forever Blowing Bubbles” is apt to describe the actions of the U.S. Federal Reserve:
“I'm forever blowing bubbles,
Pretty bubbles in the air.
They fly so high,
Nearly reach the sky,
Then like my dreams,
They fade and die.
Fortune's always hiding,
I've looked everywhere,
I'm forever blowing bubbles,
Pretty bubbles in the air.”
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