Richard Koo: growing criticismof QE2 and its implications                                                                 ...
30 November 2010rather in a balance sheet recession. This is a once-in-several-decades event in which theprivate sector st...
30 November 2010purchase of short-term government securities (and the corresponding supply of funds) toincrease commercial...
30 November 2010But in my view it is difficult for the Fed chairman to take credit for higher stock prices andbond prices ...
30 November 2010* Post-bubble recovery and rectification of trade imbalances cannot be achievedsimultaneouslyWhile there i...
30 November 2010* Even Bernanke admits need for fiscal stimulusHowever, Mr Bernanke is finally being forced to reconsider ...
30 November 2010consolidation stance, I think China—whose economy continues to benefit from thecorrect policy of fiscal st...
Online availability of research and additional conflict-of-interest disclosuresNomura Japanese Equity Research is availabl...
securities, futures and foreign exchange, issued by their foreign affiliates in respect of recipients who are not accredit...
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  1. 1. Richard Koo: growing criticismof QE2 and its implications Nomura Securities Co Ltd, Tokyo Japanese Equity Research – Flash ReportRichard Koo 30 November 2010 (issued in Japanese on 29 November The dollar has appreciated against other currencies over the past two weeks as 2010) government debt sold off around the world and Japanese equities rose. The driving factor was criticism by US economists of QE2, which was launched by the Bernanke Fed at the beginning of November, and subsequent speculation that the program could be scaled back or discontinued altogether. Please read the important Denunciation of QE2 has come not only from these academics but also from the disclosures and disclaimers conservative Tea Party. For Chairman Bernanke, known as a conservative who is close on pp. 8–9. to the Republican Party, this represents an attack from within. On the international stage, as noted in my last report, the US found itself almost completely isolated at the Seoul G20 summit, with the other member nations opposing it 18 to 2 or 19 to 1 over QE2. It would not have been difficult to conclude that the US would be forced to modify the program. * QE2 condemnation also helps brake yen’s rise The first result of this criticism was a selloff in government debt around the world and a corresponding rise in interest rates. In the US, bond prices fell sharply on the day that the economists published an open letter. Forex market participants concluded that the Japan–US interest-rate differential would not contract as much as initially projected. They responded by selling the yen and buying the dollar, halting the yen’s long upward climb. Japanese stocks, which had been lagging significantly behind global equities, finally turned higher once the yen’s rise had been checked. In summary, the yen fell, bonds slipped, and stocks rose. * Market presumes Fed would actively pursue further easing In addition to criticism of QE2 from both inside and outside the US, I think another reason for this turn of events was that the markets did not initially understand the Fed’s message. I am referring specifically to comments by Fed Governor Kevin Warsh several days after the announcement of QE2. His remarks made it clear that the meaning of the expression “adjust the program as needed,” which was contained in an explanatory article written by Chairman Bernanke when QE2 was launched, differed from the market’s interpretation of the phrase. Many initially interpreted this expression as meaning that the Fed was ready to carry out QE3 if necessary. What it actually meant, however, was that the Fed was willing to scale back or discontinue the untried policy in the event of unforeseen consequences. The tone adopted by Governor Warsh in his comments was far from enthusiastic— essentially he said that, while QE2 is not the best policy, the Fed had to do what it could. This also gave the impression that the Fed would move quickly to alter the policy if something unexpected happened. A careful reading of the explanation of QE2 published in the Washington Post by Mr Bernanke reveals that nuance, but market participants saw the document as confirming their own bias that a third round of quantitative easing was possible. * Criticism of QE2 also confused Incidentally, the arguments made by those opposing QE2 were also quite confused. Many missed the mark entirely. This confusion stems from the fact that neither the supporters of QE2 nor its critics understand the significance of the fact that the US is not in an ordinary recession but Nomura 1
  2. 2. 30 November 2010rather in a balance sheet recession. This is a once-in-several-decades event in which theprivate sector struggles to pay down debt even though interest rates are at zero.When a collapsed asset bubble has left private sector balance sheets underwater andbusinesses and households are paying down debt to repair their finances in spite of zerointerest rates, the money multiplier is negative at the margin. This means the Fed cansupply as much liquidity as it wants, but the mechanism that would ordinarily transmitthose funds from the financial system out into the real economy is no longer functional.Fed purchases of Treasury securities at such times leave banks holding cash instead ofTreasury securities. But unless there are businesses or households willing to borrowthose funds, the banks’ only alternatives are to hold that cash or to use it to buy otherexisting assets.If the banks purchase an existing asset, that simply represents a change of ownership,and there is no impact on GDP. While the price of the asset may change somewhat,there is no guarantee that the money used to buy that asset will enter the real economy.To use the analogy of an antique market, it is as though someone who had previouslyshown no interest in antiques suddenly began buying them in large quantities. Whilethose purchases could drive up the price of antiques, the positive impact of the higherprices on the real economy would be quite small in relation to the amount of moneyspent buying the antiques.In other words, there will be a positive impact on GDP if people who received more thanthey expected by selling their antiques to this new buyer used some of their profits toengage in additional consumption. However, such expenditures will necessarily be quitesmall in relation to the selling price of the antiques.* Lowering interest rates will not change behavior of private sector intent onrepairing its balance sheetIf private loan demand was at ordinary levels, Fed-supplied liquidity would support newinvestment by businesses and households via bank lending and would at the same timeincrease the money supply. The simultaneous expansion of investment activity and themoney supply would proceed in accordance with traditional money multiplier theory andhave a positive impact on both GDP and inflation.In contrast, the economic stimulus from a slight increase in the price of existing assets isonly a fraction—possibly a tiny fraction—of what can be achieved with ordinary monetaryeasing.Moreover, the fact that businesses and households are focused on fixing their balancesheets and have shown no interest in borrowing despite historically low interest ratessuggests that further decreases in (long-term) interest rates will have little effect. Unlessthe argument is that people’s behavior will change suddenly once interest rates fall tosome critical level, we cannot expect a further 25–50bp decline in interest rates toproduce significant changes.In other words, we cannot expect modest changes in the yield curve due to Fedpurchases of longer-term Treasury securities to prompt a change in private-sectorbehavior at a time when balance sheet problems have reduced the private sector’ssensitivity to interest rates to a level approaching zero.In that sense, it is a mistake to assume that the Fed’s QE2 will generate inflation, just asit was a mistake to believe that the BOJ’s version of quantitative easing 10 years agocould create inflation in Japan, which found itself in exactly the same situation as the UStoday.* Interest rate sensitivity of US private sector has fallen precipitouslyIn a speech in Frankfurt on 19 November, Mr Bernanke argued that the term“quantitative easing” was not an appropriate description of the Fed’s $600bn purchase oflonger-term Treasury securities. His reasoning was that QE ordinarily refers to theNomura Research 2
  3. 3. 30 November 2010purchase of short-term government securities (and the corresponding supply of funds) toincrease commercial banks’ reserves. The recently announced program, on the otherhand, involves the purchase of bonds with relatively long times to maturity.I suspect that Mr Bernanke was trying to distinguish the policy from Japan-stylequantitative easing, which was demonstrated to have little effect, by stressing that it wasnot quantitative easing but rather a purchase of longer-term government securities. Butat a time when balance sheet problems are forcing businesses and households todeleverage, I think the private sector is no more able to respond to changes in long-terminterest rates than it is to short-term rates.If private sector sensitivity to interest rates has fallen not only with respect to short-termrates but across the yield curve, the Fed’s attempt to supply funds by purchasing longer-term securities will have the same effect as Japan-style quantitative easing, in which theBOJ bought short-term government securities.At one point the yield on 10-year Japanese government bonds fell to a historic low of0.4%, but even that was unable to provoke a change in private-sector borrowingbehavior. In other words, the interest rate sensitivity of Japanese businesses andhouseholds had fallen with respect to the entire yield curve.More than two years have now passed since the collapse of Lehman Brothers. Duringthat time the Fed chairman has not only doubled the size of the Fed’s balance sheet tosupply liquidity to the market but has also kept interest rates at zero for two years.Despite these efforts, there has been no acceleration of US money supply growth orinflation. The Fed’s argument that this time the policy will work because it is buyinglonger-term debt is therefore difficult to accept.US long-term interest rates have also returned to where they stood before talk of QE2emerged, which suggests that Mr Bernanke’s professed reason for why the policy shouldwork has already disappeared.In summary, neither those who fear QE2 will spark inflation nor those who argue it willboost the economy understand the importance of the dramatic drop in private sectorinterest rate sensitivity.* Damage from QE2 evident in dollar weaknessA closer look at the remarks of Governor Warsh noted above and those of Mr Bernankein the 19 November speech gives the impression that both officials now recognize thatQE2 is more likely to have no effect at all than to spark inflation.I suspect the Fed’s decision to implement QE2 regardless is probably based on the viewthat, while the policy may not be particularly effective, it cannot hurt. This also recalls theBOJ decision in 2001 to launch quantitative easing as a result of political pressure.This time, however, QE2 has resulted in actual damage in the form of dollar weakness.The area in which the Fed’s version of quantitative easing produced the greatest relativechange in existing asset prices was the currency market.The dollar fell even before QE2 was launched as market participants concluded that adrop in US long-term interest rates would, all else being equal, serve to weaken the UScurrency. This is similar to the way that long-term interest rates fell prior to QE2,prompting investors to buy stocks. Nearly all media reports at the time cited expectationsof QE2 as the reason for the dollar’s decline.* Bernanke seeks to evade responsibility for US isolationIn his speech on 19 November, however, Mr Bernanke argued that QE2 was notresponsible for the dollar’s recent weakness. Instead, he attributed it to the fact that theeuro had returned to its earlier levels as the problems in Greece—which had beenweighing on the European currency since spring—finally faded into the background.3 Nomura Research
  4. 4. 30 November 2010But in my view it is difficult for the Fed chairman to take credit for higher stock prices andbond prices during this period while at the same attributing dollar weakness to externalfactors.And a closer look shows that the dollar did not fall exclusively against the euro duringthis period—it also dropped against the yen, the Brazilian real, the Swiss franc, theKorean won, and the Australian dollar. And starting in early November, when the marketbegan to doubt whether QE2 would be continued, the dollar appreciated against all ofthese currencies.Ultimately, I think Mr Bernanke is trying to evade responsibility for the humiliatingisolation experienced by the US at the Seoul G20 summit, where it found itselfoutnumbered 19 to 1.Of all the factors capable of explaining the dollar’s weakness, the Fed chairman hasfocused on the one that does not cast him in an unfavorable light and declared that to bethe primary cause. However, I suspect there are few currency market participants whoshare his view.What concerns me about his statement is the possibility that the former academic stilldoes not understand how markets operate and simply believes whatever is mostconvenient.* Political considerations also force caution in implementing QE2In any case, such desperate statements are evidence that the Fed Chairman is wellaware of the criticism of QE2 coming from both inside and outside the US. I suspect hewould be particularly worried if there were people within the Obama administration whofelt that QE2 was responsible for the humiliating sense of isolation they experienced atthe Seoul G20 meeting.Recent surveys show the American public’s trust in the Fed has fallen far more than theirtrust in other government institutions. One wrong decision by Mr Bernanke at thisjuncture could increase Congressional support for those seeking to strip the Fed of itsauthority.In that sense, I think the Fed will be very careful in administering QE2 and will be readyto discontinue the policy if it has unforeseen results.* Bernanke argues that weak economies running trade deficits should haveweaker currenciesI find Mr Bernanke’s remarks on 19 November to be extremely interesting inasmuch asthey were intended as a rebuttal of the case against the US made at the Seoul G20summit. In his speech Mr Bernanke argues, albeit in a somewhat roundabout fashion,that a weaker currency is a good thing for nations struggling with weak economies andtrade deficits.His argument is based on the assumption that exchange rates are freely determined bythe market. If that is the case, currencies in the emerging economies, which arecharacterized by high growth rates and interest rates, should appreciate against thecurrencies of the developed nations with their low growth rates and interest rates. Giventhat the emerging nations are currently running trade surpluses and the developednations are running trade deficits, this should lead the global economy in the rightdirection, according to Mr Bernanke.Specifically, stronger currencies will help curb inflationary pressures in the emergingeconomies and prompt producers there to focus more on the domestic market. In thedeveloped nations, meanwhile, weaker currencies will help stem deflationary pressuresand encourage producers to place greater emphasis on overseas markets. The endresult will be a much more balanced global economy, according to the Chairman.And if this mechanism propels a recovery in the US economy, he says, the dollar willeventually strengthen, which would also be a positive for the emerging economies.Nomura Research 4
  5. 5. 30 November 2010* Post-bubble recovery and rectification of trade imbalances cannot be achievedsimultaneouslyWhile there is something to be said for Mr Bernanke’s argument, the question is whetherit is appropriate to simultaneously pursue two goals: a recovery from the economic shocktriggered by the collapse of housing bubbles in the US and Europe, and the rectificationof ongoing trade imbalances. The concern here is that by running after two hares, we willcatch neither.With the global economy as fragile as it is today, an attempt by certain nations toincrease exports by devaluing their currencies would naturally force their trading partnersto defend themselves. After all, their own economies are not that strong.This would lead to a repeat of the competitive currency devaluations of the 1930s andthe protectionism that followed with a crippling effect on global trade and the worldeconomy. Today’s situation closely resembles that of the 1930s. As such, I think it iscritical that countries refrain from behavior that could lead to competitive devaluations.At the recent G20 meeting it was this issue that led to such heavy criticism of QE2. Othercountries criticized the US for pushing ahead with QE2 because its only impact during abalance sheet recession is to weaken the local currency. Nations like China, Brazil, andGermany in particular were angry at the way the US announced QE2 just before theSeoul summit in spite of the fact that they had made their concerns about this issue clearat the mid-October meeting of central bankers and finance ministers in Gyeongju, Korea.* What is needed now is fiscal stimulus, not monetary accommodationSo what should be done? The reason Mr Bernanke’s arguments are a dead-end is thatpolicy authorities around the world are relying on monetary policy in their attempts tojump-start the economy. The addition of fiscal policy to the mix would create many newpossibilities.By using fiscal stimulus to support GDP, countries will be able to boost theireconomies—which is essential for countries experiencing balance sheet recessions—with no change in exchange rates.At the emergency meeting of the G20 held in Washington immediately after the failure ofLehman Brothers, the 20 member nations agreed to carry out fiscal stimulus. That actionprevented a deflationary spiral and averted a global economic crisis. Once theireconomies had stabilized, however, the countries mistakenly concluded that the time forfiscal policy was over and decided that further economic support would be providedusing monetary policy.But with most Western economies now experiencing balance sheet recessions,monetary policy is unable to boost domestic demand; its only effect is to weaken thelocal currency. Only fiscal policy is capable of supporting the economy under theseconditions. Yet Western nations are still trying to provide stimulus using monetary policy,which leads to competitive devaluations.There was also a rush to devalue currencies in the 1930s as countries attempted to fightthe recession using monetary policy (in which I include currency policy) because they didnot want to increase their fiscal deficits.Mr Bernanke, a self-proclaimed expert on the Great Depression, did not understand thatthe Great Depression was actually a balance sheet recession. This has led him to themistaken conclusion that the US economy shrank as much as it did because the Fed didnot sufficiently ease monetary policy.Mr Bernanke decided to ease exhaustively in order to prove the validity of this theory,and QE2 represents the latest iteration in the cycle. We are effectively reliving the 1930s,when policymakers did not realize they were dealing with a balance sheet recession andattempted to stimulate the economy using monetary and currency policy.5 Nomura Research
  6. 6. 30 November 2010* Even Bernanke admits need for fiscal stimulusHowever, Mr Bernanke is finally being forced to reconsider his theory, as keepinginterest rates at zero for two full years while supplying massive amounts of liquidity to themarket has been unable to spark a recovery. In his speech on 19 November, the Fedchairman was clearer than before in his support for fiscal stimulus.After stating that the Fed alone could not cure the recession, Mr Bernanke said “theFederal Reserve is nonpartisan and does not make recommendations regarding specifictax and spending programs. However, in general terms, a fiscal program that combinesnear-term measures to enhance growth with strong, confidence-inducing steps to reducelonger-term structural deficits would be an important complement to the policies of theFederal Reserve.”This represents a major turnabout from a year ago. Then Mr Bernanke was arguing thatfiscal policy had fulfilled its role, that it was time for fiscal consolidation, and that anyadverse economic impact could be offset with monetary accommodation from the Fed.In this way, the Fed chairman appears gradually to be revising the views he formed asan academic. But he has yet to acknowledge that monetary policy is basically ineffectiveduring a balance sheet recession.* China responded most appropriately to Lehman collapseInasmuch as fiscal stimulus is essential to overcoming a balance sheet recession, themost appropriate policy response has come from China, which engaged in massive fiscalstimulus early on.I suspect Chinese officials are upset with the way the US and Europe have taken everyinternational conference as an opportunity to bring up the currency issue. After all, Chinahas managed to avoid recession by adopting the right policies, yet it finds itself beingblamed by the US and Europe for recessions resulting from their own misguided policies.In his speech on 19 November, Mr Bernanke praised the emerging economies—of whichChina is the largest—for their actions. Many countries, including Japan, have benefitedgreatly from China’s efforts to boost its economy with fiscal stimulus.* Currency and trade imbalances can be dealt with after economy recoversThe RMB4trn fiscal package announced by the Chinese government in November 2008was roughly three times the size of the Obama administration’s $787bn package in GDPterms. Moreover, unlike the US package, it was quickly implemented.China’s fiscal stimulus package was also implemented against the backdrop of steeplyfalling housing and stock prices. Had China not acted in the way it did, it could havefallen into the same kind of balance sheet recession now dogging Europe and the US.If China had substantially devalued the RMB in the wake of the Lehman-inspired crisis,the US and Europe might be able to make the case that China was responsible for thesubsequent recession. But that is not what happened. The Western nations have falleninto recession not because of Chinese currency manipulation but because their ownasset price bubbles collapsed, plunging their economies into balance sheet recessions.I agree that China’s currency policy is a problem. However, there is little likelihood Chinawill change its policy after seeing the Western nations focus exclusively on China’scurrency issue while putting off necessary measures in their own economies. From aChinese standpoint, it is clearly unfair for China to have to shoulder the world’s burdenwith both fiscal policy and currency policy.It would be more difficult for China to reject the arguments of Europe and the US if theWestern nations had carried out necessary fiscal stimulus before asking China to alter itsforex policy. But they have not.With a Republican victory in the recent midterm elections making it more difficult for theUS to implement fiscal stimulus and Europe having adopted a staunch pro-fiscalNomura Research 6
  7. 7. 30 November 2010consolidation stance, I think China—whose economy continues to benefit from thecorrect policy of fiscal stimulus—is unlikely to give in easily to Western demands on thecurrency front.* International coordination impossible with US authorities singing from differenthymn sheetsInstead of trying to rectify trade imbalances and spark an economic recovery at the sametime, the US and Europe should set their priorities and achieve a recovery before theyset about trying to rectify trade imbalances. The global economy is simply not strongenough to allow both objectives to be achieved simultaneously.A senior Obama administration official I met with in October held the same view andwent on to say that since the Lehman Brothers failure he had never once argued the USprivate sector should start saving more. Increased US household savings would helpcorrect the nation’s external imbalances, but would also have a negative impact on theeconomic recovery.In contrast, Mr Bernanke said in his speech on 19 November that “higher private savingwould also help.” The two positions are clearly contradictory.Similarly, Treasury Secretary Geithner stated on a number of occasions around theSeoul G20 meeting that the US did not seek a weaker dollar. But as noted above, theFed chairman said on 19 November (albeit indirectly) that a weaker currency is good forcountries—like the US—with trade deficits and low growth rates.This is clear evidence that US policymakers do not share the same priorities. I thinkthese kinds of contradictions in US policy are one reason for growing distrust of the US.The US should be serving as a leader of the global economy. But as long as the presentstate of affairs continues, I think the G20 will be unable to function in its intended role aspromoter of global coordination.Richard Koo’s next article is scheduled for release on 14 December 2010.7 Nomura Research
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