Case For QE2 Is Far From Airtight

Sir Andrew Large, a former Deputy Governor of the Bank of England, says there is some uncertainty about whether the US Federal Reserve’s second round of quantitative easing since the global financial crisis (dubbed QE2) will succeed in bolstering economic growth, as well as combating deflation and high levels of unemployment in the US.

While it is also unclear what kind of economic impact QE2 will have domestically, Large, an INSEAD alumnus (MBA ’70), expressed concern that QE2 would instead result in significant monetary outflows to emerging markets, which have already seen “very big increases in (foreign exchange) reserves”.

On November 3, the Fed announced that it would buy $600 billion in longer-term Treasury securities in the open market over the next eight months. The US central bank is striving to fulfill its dual primary mandates of achieving maximum sustainable employment and its informal price stability inflation target of between 1.75 per cent and two per cent.

US unemployment remains persistently high, reaching 9.6 per cent in October, while inflation is at the slowest pace on record at less than one per cent. That’s despite the Fed’s earlier injection of $1.7 trillion into the global financial system to avert a worldwide economic depression.

Furthermore, banks remain unwilling to lend despite sitting on reserves of over $1 trillion, capitalised by the Fed’s purchases of Treasuries and mortgage-backed securities between December 2008 and March 2010.

Rising inflation?
While conceding that the Fed’s primary mandates necessitate its quantitative easing actions, Large nonetheless has “some reservations” about them. Asked whether inflation is a real concern, Large suggests that the idea that a little bit of inflation to reduce the US debt burden “might well be a twinkle in a few policymakers’ eyes”.

“Will quantitative easing lead to inflation? The answer is maybe,” Large told INSEAD Knowledge in Singapore. “On the other hand, I don’t think one should overlook the fact that the Fed can easily reverse the policy stance if they think that inflationary expectations are rising too quickly.”

“So I don’t think that just because they have done this it means that inflation’s an inevitability.”

However, Large believes that Germany is right to “point out the dangers” of printing money and pumping it into the economy, bearing in mind the hyperinflation experienced in the Weimar Republic following the first world war.

“It’s seared in the German consciousness and I think one respects that,” says Large. “I do think that the dangers are perhaps slightly overstated, given the possibility the Americans have to withdraw the stance they are taking.”

Currency war?
The dollar has been weakening against a basket of currencies since June, fuelling talk of a currency war.

Limiting his comments to the mutual recriminations between the US and China about currency manipulation, Large sees good reasons in the US wanting to devalue its dollar, as well in China delaying the rise of its currency.

“The Americans obviously would like to see the renminbi significantly stronger. It’s all about jobs in the States effectively,” he says. “The Chinese, on the other hand, are concerned in two senses. One, I think they themselves are the recipient of a large amount of the liquidity that’s been created, but the other is that if they were to revalue the renminbi too rapidly, it could give rise to social unrest in China itself and they clearly are very worried about that.”

“So you have two points of view here and it’s very difficult to know how to reconcile, and to a large extent I think it is a matter of timing. There’s little doubt that the Chinese can see the validity of the argument that over time the renminbi should adjust. Equally, they need time to make sure that the social cohesion can hold together.”

Return to a gold standard?
Is the time right then for a return to linking currencies to a gold standard? In a recent article for the Financial Times, World Bank President Robert Zoellick called for the return to a modified gold standard, a system in which the monetary unit is a fixed weight of gold.

“I don’t know the answer to that,” says Large, adding that he doubts many people, including Zoellick, think that’s going to happen. Another scenario, says Large, is that gold could be included in a basket of currencies, which is “a less extreme solution”. Even so, he has “significant doubts” about it gaining international acceptance.

Basel III

The challenge facing the world economy is “too much liquidity”, which has led to excess leverage and debt, says Large. While the latest Basel III international regulatory framework requiring banks to increase their capital ratios is a “positive step” in mitigating systemic risks, other measures are needed to ensure a more secure global economic system, Large argues.

“There needs to be a policy framework to handle systemic issues, if you like, alongside monetary policy,” says Large.

“People have got used now to the fact that monetary policy frameworks exist and they’ve been relatively successful in securing price stability. The problem is that although monetary policy has secured price stability, price stability has not secured financial stability. And to secure financial stability, I would advocate the need for a parallel policy process to be put in place.”

Specific policy instruments could include reducing loan-to-value ratios to check excessive lending in the housing market, suggests Large, adding that there are a variety of capital controls and regulatory instruments that policymakers can use.

Not out of the woods
To be sure, the buoyant economic growth in North America and Europe in the years leading up to 2008 was partially “illusory”, Large says. He explains that it was based on growth in debt, which had risen to an extent that needs to be “clawed back”. Without doing so, the threat of further financial crisis remains.

“So if you are going to claw the debt back, then that will inevitably have an impact on growth … I’ve heard it argued that were it not for the crisis that took place in 2008, economies like the United Kingdom would be 10 per cent higher today than they presently are. That may be true, but I would suggest the starting point was already five per cent too high and therefore, yes, there has been a reduction of GNP (gross national product) below the sustainable rate.”

“But it’s nothing like as great as it otherwise would have been, and it’s possible that we’ve still got to endure some further pain of getting it back to a sustainable level.”

Chaos in the eurozone
In Europe, the survival of the euro has come under scrutiny, amid renewed fears that Spain, Portugal and Belgium could join Greece and Ireland in needing financial bailouts to avert economic collapse. With growing sentiment in Germany, Europe’s largest economy, for a return to the deutschmark, does Large think the United Kingdom made the right decision in not joining the Eurozone?

“Clearly the risks you take in creating a currency union are greater if you don’t have a fiscal union, and there is not a fiscal union in Europe,” Large replies. “The stability and growth pact didn’t provide it and so now there’s great effort obviously being made to develop a proxy for fiscal union, because without it, ultimately currency unions do run into difficulty,”

“Apart from the rather parochial reasons that the British may have had in terms of keeping out (of the eurozone) … I think their real disquiet was because they took the view that, ‘Look, we ourselves cannot see our way to being part of a fiscal union. If we are not going to be a part of a fiscal union, then we think the risks of being involved in this may be greater than makes sense’. So I think there are two sorts of basic reasons, one was very parochial and the other, I think, was more deep-seated.”

[This article is republished courtesy of INSEAD Knowledge
http://knowledge.insead.edu, the portal to the latest business insights and views of The Business School of the World. Copyright INSEAD 2023]