QE2, With the Benefit of a little Hindsight

Long term interest rates are rising, US trading partners are incensed, commodity prices are soaring, Fed credibility is crumbling and QE2 is just beginning.
  What's worse is that we have sacrificed all of this and even the economists in favor of qe2 feel that it is too small to be effective.  Actually, economists that strongly favor QE2 are suddenly in short supply.  In only a few weeks momentum has moved sharply away from support for QE2.

The next time an IMF economist breaks out his X-Y axis and begins to explain the minutiae supporting the wisdom of a currency debasement, take a long pause before responding.  An invariable quality of sound economic policy is that it makes intuitive sense.  Spending our way to prosperity does not seem intuitive, neither does destroying the value of our currency to restore our economic vitality.  There are some rational and well respected arguments that can be made for both of these practices, although in moderation.  The problem is that moderation is  in the rearview mirror.   We are on the equivalent of our 12th drink with respect to fiscal and monetary stimulus.

A great economist said "There is no subtler, or surer means of overturning the existing basis of society than to debase the currency.  The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which only one man in a million is able to diagnose."  I might have guessed that Milton Freidman or Friedrich Hayek said this.  I would have been wrong.  It was Maynard Keyenes.  Today, the remaining economists on the quantitative easing bandwagon are the same ones that have invoked Keyenes as justification for every failed and irresponsible policy decision of the past two years.  No single economist holds a monopoly on Keyenesean credibility although there is no shortage of those who sully his legacy by behaving as if they do.

Recognizing the importance of expectations seems to be making a comeback however.  The Rational Expectations Theory of economics tells us that on average, the expectations of economic agents will be correct.  Economic "agents" are consumers and business people making buying, selling and investing decisions.  While each agent might individually make mistakes, in the aggregate they will be correct.   Aggregate expectations among economic agents are currently grim.   This is why business spending, investment and employment all remain low.  When individual economic decisions are viewed as a function of expectations, it is clear that further monetary or fiscal stimulus will only make matters worse.

US creditors will tire of seeing the value of their dollar denominated loans to the US shrink along with the value of the dollar.  Our creditors have been very patient so far, but it is folly to think that this patience is limitless.   The patience of our creditors is a function of the US economy's size and importance.  As US importance diminishes, so will the patience of our creditors.  Pontificating about the duration of this patience is little more than gambling.  When their patience does run out, the ensuing crisis could make the last one look like a picnic.

US creditors realize that as our debt continues to reach new stratospheric levels it becomes increasingly unlikely that they will be paid back in full.  At some point, US creditors are going to demand higher yields for the risk they are taking and the US will be forced to pay more to attract buyers of our debt.  Because the average duration of US debt is less than 5 years, this would mean that a rapidly increasing portion of US income would be used to service debt.  When short term debt is rolled over, it would be rolled over at much higher rates and debt service payments would increasingly crowd out other forms of spending and investment.  The value of existing US debt will plummet as interest rates increase.  Harvard Economist Niall Ferguson said recently "US Debt Is A Safe Haven Just Like Pearl Harbor Was A Safe Haven In 1941".

Although US inflation remains low, the reliability of US inflation measures is highly suspect.  Inflation is a silent thief.  Gold, corn, coffee, rice, copper, sugar, cotton and silver prices are all up over 50% in the past two years.  Oil prices, which were a contributing factor to the great recession, just hit a 25 month high.  Inflation transfers wealth from savers like China, Japan, and anyone with a 401k, to borrowers like the Federal government.  Keyenes said it more eloquently, but currency debasement is legalized theft.

Although QE2 is often rationalized in terms of benefits to the US export sector, a weak dollar increases input costs for manufacturing processes, which in turn makes our goods less competitive and US firms less profitable.  Considering the extent to which the US is a net importer, the magnitude of this tradeoff should not be underestimated.

Keynesian and Monetarist approaches to economic recovery have both been pursued with abandon.  Supply side stimulus has been extraordinarily small in comparison and the expectations of business executives has been completely ignored.  The wasteful $787 Billion US stimulus package could instead have been used to reduce US corporate tax rates by 50% for a period of 6 years.  This would have led to massive business investment, a larger tax base, hiring and economic growth and would have resulted in the development of many new productive and innovative technologies.  Instead of a jobless recovery, such policies would have led to significant employment growth.

QE2 will likely lead to another boom bust cycle, and this bust will be hard to pin on any US industry.  Hot money from QE2 is further inflating commodity prices and emerging market real estate prices.  It is also preventing the US housing market from finding its natural bottom, where normal growth can resume.  But the real risk is our creditors.  To say that they are agitated is an understatement.  Business executives understand the potential for crisis and these expectations are reflected in their conservative decision making.  When they see massive government debt and a plummeting dollar they hunker down and prepare for the worst.  Only when they see the government behaving like responsible grown-ups will they feel safe to invest and hire.