QE2: A Titanic loss?

The financial Times has an interesting opinion piece entitled “Capt Bernanke on course for icebergs” by Edward Chancellor.

Let’s put to rest the idea that fiscal activities by the Fed are going to be sufficient, let’s also recognize that not all unemployed people are structurally deficient in skills for today’s workforce. What we have is a fall in demand that can be restarted by large scale government spending on projects. But that this is politically not probable in the next 2 to 6 years due to the hung nature of government with a split partisan Congress, Republicans and Blue Dogs terrified of the deficit and proposing paradoxically to lower it by lowering taxes on the rich, and the retrenchment of the consuming middle class due to deleveraging of the household.

The major problem with QE2 at this time is that it will not affect employment nor will it fire up inflation since deflation is the real risk in the economy today(IMHO); though it will create a run up in assets and a better capital position at the banks (Mr. Chancellor writes):

The aim of quantitative easing is to dispel deflation and reduce unemployment. Yet the plan is beset with controversy. It’s not clear whether it will have much effect on the real economy or whether the Federal Reserve chairman has fully considered the long-term consequences of his unconventional policy. Investors have already bid up asset prices in anticipation of the central bank’s move. But the financial gains from quantitative easing are a fool’s gold….

The credit system is not dislocated and banks are willing to lend, according to the Fed’s survey of senior loan officers. The problem is not with the supply of credit but with lacklustre demand from the private sector. Any new money created by the central bank expanding its balance sheet may well end up adding to the existing pile of more than $1,000bn of excess reserves in the banking system….

Mr Bernanke is tilting at windmills. Not only is deflation absent in the US, it is arguable whether mild deflation is economically damaging. And even if it were, no one knows whether asset purchases by the central bank could succeed in reversing a deflationary tide. After the great credit binge, deflation reflects the desire of households and companies to pay down their excessive debts. It is a symptom, not a cause, of a problem.

I think that deflation is a risk and more and more economists are arguing that the US may enter a second ‘lost decade,’ (2000-2010 is already being considered a lost decade with no appreciable growth over the two end points, however much froth there was in the middle.)

Chancellor also pulls out the canard that the employment is structural. THis is a economists term for (it’s not responding to cyclical changes so we don’t really know what is causing it.) The cause is most certainly not as Mr. Chancellor would have it:

…much of the current unemployment may be structural in nature. People who can’t find a job because they are in the wrong place with the wrong skills won’t find their prospects improved by the central bank acquiring Treasury bonds.

Paul Krugman in ‘What We Learn From Search Models,” a review of the Nobel Prize winning work of Peter Diamond, Dale Mortensen and Christopher Pissarides had this conclusion about that [notes from dp]:

And given the debate now underway about whether we’re mainly facing a rise in cyclical or structural unemployment, it’s definitely worth noting that [Diamond/Mortenson/Pissarides] give us a simple way to make that distinction:

The economy, however, is subject to two types of shocks with quite different effects. Changes in the level of aggregate activity cause rates of job creation and job destruction to move in opposite directions, while changes in the intensity of the reallocation process cause them to move in parallel.

Overwhelmingly, what we’ve seen is a simultaneous fall in vacancies and rise in unemployment, which tells us that this is an aggregate demand shock. […not structural unemployment]

I liked Mr. Chancellor’s close:

In recent months, brokers have eagerly anticipated the launch of QE2. Their clients have been enjoined with nautical metaphors to “ride the liquidity wave”. But they have identified the wrong ship and the wrong location for the cruise. Rather than steering towards balmy waters, Captain Bernanke has set course towards the iceberg fields. Full speed ahead!

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