TWN Info Service on Finance and Development (Nov10/14)
24 November 2010
Third World Network

Dear Friends and Colleagues,

How the US can fix its QE2 problem

An article by Kevin Gallagher and Stephany Griffith-Jones appeared in the Guardian on 18 November on the issue of quantitative easing by US Federal Reserve. 

The authors argue that the US should place prudent capital regulations on the outflow of speculative capital leaving the US for emerging economies via the carry trade. This would help prevent future crises in emerging economies, as crises harm all countries and are therefore a collective action problem. 

Please find the article below.

With best wishes,

Third World Network

How the US can fix its QE2 problem 

G20 countries had issues with the US devaluing the dollar, but the solution lies in cooperation on capital controls

Kevin Gallagher and Stephany Griffith-Jones, Thursday 18 November 2010 12.00 GMT

Ben Bernanke has been criticised from different sides and perspectives for quantitative easing. From one side, inflation hawks prefer austerity over expansion. Those who favour expansion and growth have valid concerns that it may not work and, instead, have negative global effects. At the G20, the United States got criticised  rightly by emerging countries for the negative impact of QE2 on their economies.

The results of the recent US elections make it very difficult for the US to pursue the first best policy to keep its economy recovering: further fiscal expansion, for a time. As Keynes taught us, and we have seen during numerous crises, private investment and consumption will not recover on their own (due both to over-leveraging and lack of confidence), without the stimulus of aggregate demand, which only governments can give in these particular circumstances. Once the recovery is on track, fiscal policy needs to contract, to avoid both overheating and excessive public debt.

The Fed has already brought the short-term interest rate to zero, so Bernanke, to his credit, has ventured into the emergency toolkit. The Fed chairman should be applauded for his willingness to think past convention. As one of the last policy-makers in developed countries with significant economic power, he is now almost the sole voice for expansionary economic policy.

However, on its own, QE2 may, indeed, not be enough to restore the US economy to growth; and it will contribute to further overheating of asset prices in the emerging economies, which could not just complicate macroeconomic management for them now, but also increase the risk of future crises.

To ensure QE2 helps the US economy to grow, mechanisms need to be found to channel the additional liquidity created by the Fed to the real economy. The key is to expand credit to small and medium-sized enterprises, starved of funds at present, and to finance large investments in infrastructure, including that required to generate clean energy.

Policy-makers must exercise creativity to help achieve this. The Europeans have a massive institution, the European Investment Bank (EIB), which last year lent more than $100bn; the US needs to create similar mechanisms quickly, or use existing institutions to lend more to the private sector. The Europeans, in turn, should further expand EIB lending.

Internationally, if the US dug into the emergency toolbox again, it could place prudent capital regulations on the outflow of speculative capital from the US via the carry trade; this might help avoid future crises in those countries, which would harm not only them, but also the US and the world economy. More broadly, it is time policy-makers stopped letting the financial sector tail wag the real economy dog.

Before and at the G20 summit, many emerging market politicians and well-known economists voiced serious concern over the global effects of quantitative easing. Increased US liquidity may pull dollars out of the US and invest them in nations with higher interest rates for rapid speculative return. Known as the carry trade, such speculative flows push up the value of emerging market currencies and create asset bubbles.

It is for this reason that the US was criticised at the G20. Brazil, with interest rates over 10%, has seen an appreciation of over 30% due in part to the carry trade, and was most vocal in Seoul.

One remedy to the problem already under way is the use of capital controls in emerging markets. Many nations such as Brazil, India, China, Argentina, Taiwan, Thailand, South Korea, Peru and Indonesia have put in place controls to limit excessive inflows. Such controls have been sanctioned by the IMF a landmark shift.

The problem is that on their own controls from recipient countries may be overwhelmed by the sheer scale of the inflows, with investors often finding ways to evade them. Given that the majority of the carry trade effect will come from the US, the United States could start regulating the outflow of capital due to the carry trade.

Controls on short-term outflows would facilitate the liquidity created by the Fed to stay in the US and have a better chance of going toward productive investment. Such investment could help developing countries via trade, rather than causing speculative capital to flow to emerging markets and cause havoc to their financial systems and their economies.

By stemming criticism from emerging markets, the US may find more allies for a global growth agenda. Developing countries have deployed expansionary policy in the wake of the crisis, and it is working. It is important that their efforts are strengthened, and not undermined, by hot money. Together, they could pose a legitimate alternative to the austerity-ridden Europeans and new members of the US Congress.  Guardian News and Media Limited 2010