Brian Fallow: Printing money act of desperation

With the world economy still in a delicate state it is unfortunate that what we get from Washington is divided government and monetary policy desperation.

The two are linked.

One reason for the Federal Reserve to crank up the (virtual) printing presses and embark on quantitative easing is the prospect of a Congress deaf to Keynesian arguments about the need for further fiscal stimulus to energise the United States economy.

And, of course, the conventional monetary policy instrument of cutting an overnight interest rate has not been available for a couple of years now. The US equivalent of our official cash rate is effectively zero.

That leaves quantitative easing.

By buying US government bonds with US dollars conjured into existence by its own fiat, the Fed would be looking to accomplish two things.

It would increase demand for those bonds, all else being equal, driving up their price and thereby driving down yields.

As US government bond yields are the traditional benchmarks for longer-term interest rates generally, other rates should follow suit.

It would also inject liquidity into the banking system, as it did during the first bout of quantitative easing at the height of the global financial crisis.

Whatever the benefits then, there are doubts about how much good this will do now.

Is it the level of interest rates that is holding back the US economy, keeping unemployment high and output way below capacity?

Are banks not lending more because they lack the funds?

Not really.

Rather, as in New Zealand but only more so, it is caution on the part of households and businesses.

The spectacle of the central bank throwing caution to the winds is unlikely to change that.

The last decade's boom - the era of reckless lenders and feckless borrowers - and the subsequent bust, cast a long, cold, dark shadow.

The US unemployment rate seems stuck at about 9.5 per cent and the collapse in house prices has left one mortgage in four "under water", where the property is worth less than the amount owing on it.

This makes American workers less mobile than they would normally be.

As in this country, people have responded by raising their savings rate by about 4 per cent of disposable income, which means spending less.

This has not brought the US economy to a standstill, however. In the September quarter it grew at an annualised rate of 2 per cent. But much of that was firms rebuilding inventory rather than sales, and exports declined.

So will lower interest rates put more money into Americans' pockets by allowing them to refinance home loans?

One commentator who thinks not is Robert Reich, a former secretary of labour in president Bill Clinton's Cabinet and now a professor at the University of California, Berkeley.

Banks are now required to follow strict lending standards, Reich says.

"They won't lend to families whose overall incomes have dropped, who are still burdened with high debts or who owe more on their homes than their homes are worth. This means most families will not qualify for refinancing."

Goldman Sachs' chief US economist, Jan Hatzius, does not think quantitative easing is a panacea but says it is not completely ineffective either. "I do think it boosts growth by half a percentage point per trillion dollars," he told Bloomberg.

Bill Gross, managing director of the fund manager and bond market titan Pimco, says the US is caught in a liquidity trap where interest rates or even trillions in asset purchases by the Fed may not stimulate borrowing or lending, because consumer demand is just not there.

"Escaping from a liquidity trap may be impossible, much like light trapped in a black hole. Just ask Japan. [Fed chairman] Ben Bernanke, however, will try. It is, to be honest, all he can do," Gross said.

Another argument for quantitative easing, advanced by Nobel laureate economist Paul Krugman, is to ward off the risk of deflation.

Core inflation (which excludes energy and food prices) has been falling since the crisis.

The question is whether this is merely a cyclical ebb tide or a more sinister rip that is pulling the US, like Japan in the 1990s, into deflation.

That would be a calamity for them and for the rest of us. Falling prices encourage people to defer buying things because they will be cheaper later.

That dynamic, where consumption represents 70 per cent of the economy, is the last thing the US or its trading partners need.

Deflation also increases the real burden of debt, and Americans have plenty of that.

For those who take that risk seriously, the inflationary consequences of quantitative easing are seen as a benefit rather than a drawback.

Perhaps the major mechanism for quantitative easing to spur growth in US economy, however, is to reduce the international value of the US dollar, boosting the competitiveness of its exports and of locally produced goods that compete with imports.

The effectiveness of this, however, will be stymied at least partially by China's policy of allowing only a creeping revaluation of the yuan relative to the US dollar.

It crates the spectre of a world divided into two camps - a US dollar bloc including the US, China and the petro-economies - and the rest of us, with exchange rates driven higher as the US debases its currency.

Countries whose currencies are already buoyed by high commodity prices, including New Zealand and Australia, are particularly vulnerable.

A tsunami of yield-seeking hot money could be coming our way. The last one proved destructive. We have yet to recover.

A flurry of central bank meetings over the next few days, including the European Central Bank, the Bank of Japan and the Bank of England, may give some guidance on how the major players will react.

Is it too late to hope that policymakers will grasp the simple point that beggar thy neighbour is foolish policy when thy neighbour is thy customer?