Here We Go Again

By Friday, October 15, 2010

Quantitative easing (QE) seems to be one of those sexy terms used in the same sentences with phrases like “jumpstart the economy” or “bolster the recovery.” In the U.S., it seems QE is not only something people talk about, but it is also becoming a distinct possibility. Apparently, Washington is considering another round of bailouts. In the current economic context, however, more QE could only mean more trouble in the long term.

What do we know so far? Not much. So far there were only hints and insinuations that the U.S. Federal Reserve Board could soon start buying more bonds, a decision that could be made around the time the Board next meets in early November. The idea is to flush more cash into financial systems, keep or even lower long-term interest rates, and make sure prices remain stable and do not veer off either up or down. In return, that should create an improved environment for more lending and for more spending by businesses and consumers.

Now, in theory, QE could work. It could indeed jumpstart the economy and it could prevent the recovery from deteriorating any further. How? More money in the system could serve as a catalyst for people to stop hoarding cash and start spending more. If people start spending more, the housing market could stabilize as well. And as long as interest rates remain low, more homeowners could stay in their homes and be able to refinance their loans.

There is another beneficial aspect of hinting at more economic stimulus, at least on the surface. Just talking about it appears to have boosted investor confidence. As a result, stock markets have rallied in recent trading sessions. Now, as far as I am concerned, this is a mirage. After the crash of 2008, Wall Street has somehow detached itself from the rest of the economy, and it should not be used as a gauge of economic activity anymore.

Admittedly, if anything is going to boost the global recovery, it will be concrete improvements in the U.S. economy; hence the anxiousness of the Fed and Washington to get this ball rolling. The only problem with QE is that it has been tried before and it didn’t work.

In the long term, if interest rates remain substantially suppressed and if the world financial systems remain substantially awash in money, at some point, these two variables will become untenable. What are likely to break the spell first are interest rates. If, after potentially years of interest rates being ultra-low, they start rising rapidly, the real shock to the economy could be immeasurable. As one economist put it, keeping interest rates artificially low has “…a rubber band effect. The more you pull it back, the worse snap you get.”

Excess money supply is already bringing as much harm as it is bringing good, if not more. It is clear that massive bailouts in the wake of the crash of 2008 have yielded some, albeit limited, benefit. But what the bailouts have surely brought is chaos to currency markets and a potential long-term demise to the U.S. dollar.

Enough money has been thrown into this mess and the laws of logic have been defied long enough, too. It is time to recognize that this recovery is not something that is going to happen either quickly or easily. It is also time to stop taking the path of least resistance. Case in point, more money in the system could force the economy to crash and burn, at which point perhaps there would be nothing anyone could do to help.