Sunday, March 20, 2016

Why QE will not resolve the world's economic woes

Eight years back, the US sub prime mortgage crisis led to a global financial downturn. As many western economies went into recession, their central banks resorted to all available monetary tools to revive the economy. The immediate aftermath of the crisis led to a freezing of liquidity in the global financial system. As the US federal reserve reduced interest rates to near zero and announced plans to purchase billions of dollars worth of bonds (read: announced plans to print billions of dollars of currency notes), it was the obvious countermeasure to ease the financial system and prevent an economic crash. Eight years later, the interest rate is barely above zero. The stock market has had a multi fold rise bull market in the past 7 years. However, GDP growth is abysmally low. The situation is even more alarming in Europe where the ECB has brought interest rates down to negative, but inflation and GDP growth are hovering around zero.

Economics is one of my favorite subjects, The events in the last 7 years have defied most macroeconomic concepts that I have studied. 
  • When a country reduces interest rates, its currency value decreases. Proven wrong: The USD has consistently and significantly increased in value against all currencies in the past 7 yrs.
  • When a country's debt and trade deficit increase, its currency value decreases. Proven wrong again: US govt debt levels and trade deficit is rising at unsustainable levels, yet the USD continues to grow stronger.
  • Lower energy and raw material prices will boost economic growth. Proven wrong: The crash in global commodities has led to grave concerns about global growth.
The world of global finance and macroeconomics is indeed strange. Anyway, let me come back to the topic of this post.

QE will not revive global growth
The past 7 years of QE (Quantitative Easing) has pumped trillions of dollars into the market, but resulted in very little economic growth. 3.5 Trillion dollars have been pumped into the economy resulting in GDP growth of around 8%. During the same time, the US stock market has risen by an astronomical 175%! This tells me that the money went into inflating asset prices rather than into real economic activity. Companies have been borrowing money to buy back shares, increase dividend payouts or other such measures to boost their share prices. Not a lot of money has gone into building facilities/factories, expanding capacity, and other such "real" investments in business expansion. The primary reason for this is that businesses don’t have long term confidence on the economy to make bold decisions on business investments. That is natural when an economy is recovering from a crisis. In a similar situation, countries like India, China or Russia will see the government take center stage in reviving economic activity through infrastructure and other projects. I am disappointed that this did not happen in the US. The government could’ve spent money on NASA, R&D funding, upgrading their military or improving the infrastructure. Even a developed country like the US will have opportunities for infrastructure improvements. Such activities will put money in people’s hands faster and in turn improve spending, confidence and economic growth. Perhaps political reasons constrained the government from stepping up federal spending. Basically, the government decided to rely solely on Monetary policy stimulus to pull the economy out of trouble, and refrained from using any meaningful Fiscal stimuli. To me, that is a risky move and could prove to be a costly mistake.

Future Outlook

The future outlook for the US economy is bleak. Loose monetary policy has its limitations and there is a lack of political will to engage in fiscal stimuli. The economy is set to start gently rolling down a slippery slope. 3-4 years down the line (maybe earlier), the slope will seem more like a cliff with dire consequences. Only two things can save the US economy: One: War – US engages in a major military conflict that can revive the defense and construction sectors, which will have a multiplier effect – or Two: A massive recovery in Chinese and Indian economies which can have a multiplier effect on the overall global economy and the western economies ride the wave and pull themselves out of trouble.

Frankly, the US will be much better served if the government takes up Fiscal stimulus measures to help the economy. If there is one country in the world that doesnt have to worry about increasing fiscal deficit having any impact on their credit worthiness, its the US. They will be "not smart" to lost this opportunity.

P.S.: I began writing this blog on March 10th after the ECB reduced interest rates further into negative territory. That move by ECB triggered several conversations within US about the possibility of negative interest rates by the US Fed - which is crazy! Recently I saw an article from Ben Brenanke that mentions the limitations of monetary policy and the need for fiscal measures. While my post is more generalized, Ben's article will have more specific details for those of you that are eager for such information.