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Notes to myself, possibly of interest to others.
-- Bill Northlich

Thursday, October 28, 2010

On QE2 (again) (long - sorry)

"The upside of QE is limited. The money simply won't go to where it's needed, and the wealth effects are too small. The downside is a risk of global volatility, a currency war, and a global financial market that is increasingly fragmented and distorted. If the U.S. wins the battle of competitive devaluation, it may prove to be a pyrrhic victory, as our gains come at the expense of others—including those to whom we hope to export."
---Joseph Stiglitz

Brad DeLong says about the above:

"As I understand it, Joe Stiglitz adopts his standard segmented-capital-markets view and makes three claims:
  1. The problem is one of impaired capital on the part of small banks and impaired collateral on the part os small enterprises--a credit channel problem--and quantitative easing in Treasuries will not help that problem.
  2. Quantitative easing will raise expectations of inflation on the part of financiers--and so will raise long-term nominal interest rates--without raising expectations of inflation on the part of industrialists, and so it will raise the perceived cost of capital to businesses and so diminish investment.
  3. Quantitative easing will unleash a process of combined and uneven quantitative easing across the globe that will create dangerous exchange rate and trade volatility.
Therefore we should not do it.

I, by contrast, would say that to the extent that quantitative easing raises expected price levels ten years hence, it will raise the value of collateral. I would say that quantitative easing gives small banks a chance to sell assets to the Federal Reserve and so improve their capital. I would say that even a bond bubble--a topic I have a very hard time wrapping my mind around--is dangerous only if leverage means that the losses from its end are concentrated in key financial institutions. I would agree that quantitative easing is like the scene from Monty Python where they are trying to catch fish in the river by hitting them with a log.

But when you need fish, and when all you have is a log, you try to catch the fish by hitting it with a log.
Don't you?"
Bill - As everyone knows, I am a great economist who has been shamefully overlooked by the Nobel committee.  Nevertheless, I'll put aside my disappointments and deliver myslef of my own take:  Both Stiglitz and DeLong are right.  Stiglitz does make the points in his article that DeLong effectively counterpoints above,  But DeLong does not really say anything about the two things in Stiglitz's paragraph quoted above - which I find the most interesting:
  1. The upsides of QE2 do not appear to be compelling, and,
  2. The money from the fed will in fact leak out into the world and not force open the lending door at US banks.  That is, the issue is not as in DeLongs third bullett that QE2 money causes imbalances out in the world, it is that it leaks out* of the US to begin with.
So, I think the overall case for QE2 is indeed very slim.  Still, in the end, Brad is right:  Since you have basically religious zealots (of all religions, including fanatic Invisible Handians) in congress, and, indeed, abounding in the land at large, you basically only have one option to try to help the country avoid 10-20 years of third-worldish economic life:  QE2.
*A good description of the "leaking out" (as opposed to Crowing Out") (joke) is by Andy Xie.  In somewhat convoluted syntax, (whole article recommended)
While QE doesn't affect the domestic demand significantly, it affects the currency market enormously. When the Fed expresses its intention for more QE, the market makes certain assumptions about what would occur. When the Fed buys treasuries, say US$ 500 billion, bondholders as a whole have the same amount in cash. Where does the money go next? More cash should lead to currency depreciation. Hence, it makes sense to sell dollars and buy foreign currencies. The lower dollar would increase the prices of risk assets like commodities and emerging market stocks. Hence, it makes sense to go into these assets too. Hedge funds would borrow dollars and buy such assets to front run other investors. Before the Fed implements QE 2, these asset prices move first. In theory, when the QE 2 is implemented, other investors would do what the hedge funds have done. The latter can unwind their positions and pay off the debts with profits. In reality, other investors may hang on to cash, and the hedge funds, their risk positions.

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