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Keep It Simple. Get It Straight


As usual, the occasion of the G-20 Summit gives rise to discussion by leftists of some current economic issues. And as usual the danger of crack-pot analyses growing in vacuums of economic ignorance is apparent. Here is some simple straight talk.

(1) Quantitative Easing by the Federal Reserve Bank: The Federal Reserve Bank announced that it is going to buy $600 billion dollars worth of medium and long-term US Treasury Bonds. That is what “quantitative easing” is, nothing more, nor less.

The Fed often engages in this kind of monetary policy, ordinarily known as an “open market operation” because the Fed is purchasing Treasury bonds in the market that is “open” to all who wish to buy or sell Treasury bonds. These are Treasury bonds that have yet to mature which were sold at some point in the past by the Treasury at an “auction” when the federal government needed to finance a past deficit in the federal budget. Since the Fed pays for the Treasury bonds it buys with “money,” this means those who owned the bonds the Fed purchased will now have “money” instead of bonds. If and when they deposit that money into the banking system the banking system will then be able to create even more “credit money” if the banks choose to use some of their new deposits to make new loans. The only reason there is a special name in this case – “quantitative easing” – given to the expansion of the money supply through an open market operation is that usually the Fed buys short-term treasury bonds – bonds that mature in 30, 60, or 90 days, or maybe a year — when engaging in open market operations to expand the supply of money in the economy. This time the Fed deliberately chose to do something they seldom do, buy Treasury bonds that mature in 10 to 30 years. This is a sign that the Fed understands that the potential of normal open market operations has been exhausted.

When anyone buys bonds it pushes interest rates down for anyone who wants to borrow. The Fed buys bonds hoping that the lower interest rates will stimulate more economic activity by businesses and consumers who can borrow to invest or consume more cheaply. If the Fed buys short-term bonds it drives short-term interest rates lower. Since short-term interest rates are already very low, they are hard to drive down further right now, and unlikely to stimulate new economic activity. Current short-term interest rates are already so low that the cost of borrowing short-term is clearly not what is preventing people from undertaking more economic activity. On the other hand the Fed believes that long-term interest rates which are currently somewhat higher may be preventing some from engaging in economic activity requiring long-term loans. That is why the Fed took the unusual step of buying medium and long-term treasury bonds hoping to drive down interest rates on long-term loans.

Is this likely to yield a significant increase in economic activity, i.e. stimulate the real economy and induce the private sector to start hiring back some of the 25 million unemployed or underemployed Americans? While there are economists who believe that monetary policy is a more powerful stimulant that fiscal policy, this is generally not true. Since the economy has not recovered the right wing claims that the fiscal stimulus Obama negotiated with Congress when he first took office did not work. This is completely untrue. The economy would have shed more jobs in absence of the fiscal stimulus that was passed. Instead, the problem is the fiscal stimulus was too small. In fact, the decreases in state and local spending largely canceled out the meager federal fiscal stimulus meaning that in grand sum total we have had practically no fiscal stimulus at all. On the other hand, we have already tried several huge monetary stimuli. In other words, whereas the power of fiscal stimulus to create jobs has yet to be tested, we have already unleashed unprecedented monetary stimulus, and there is every reason to expect this new “quantitative easing” will yield diminished returns.

In short, it is unlikely current rates of interest for those seeking to borrow long-term are the major reason businesses are not increasing investment and hiring. So why is the Fed doing it? Simply because the 2010 elections have shut the door on any hope for the one policy that could put people back to work – a significant fiscal stimulus. Stalemate on fiscal stimulus for the foreseeable future has forced the Fed to toss up a hail-Mary pass and pray it gets caught.

Is this somehow a new, big give-away to the banks? Not really. Any time the Fed expands the money supply it increases deposits in the banks and provides them with the opportunity to make more loans, which are generally profitable since banks pay a lower rate of interest on deposits than they charge for loans. But this is true whenever the Fed increases the money supply, by whatever means it chooses to do so. Besides, right now banks are sitting on large amounts of un-loaned deposits, known as “excess” or “free reserves,” which they are not lending. As a matter of fact that is one of the problems. After the taxpayer bailed out the banks by overpaying for large quantities of their toxic assets through the Bush/Paulson TARP, and then again through the Obama/Geithner “Son of TARP,” and after the Fed handed the banks a “gift that keeps on giving” by lowering the rate of interest it charges banks it lends to, known as the “discount rate,” to practically zero, which the banks can turn around and use to buy Treasury bonds paying a positive yield at zero risk, the banks have still not seen fit to perform their socially useful function and make loans to businesses and credit worthy customers to help get the real economy up and running again. So unlike TARP, Son of TARP, and the discount window giveaways, the problem with quantitative easing is that it is unlikely to stimulate the economy much, not that it is yet another undeserved subsidy for the banks.

Why did other countries at the G-20 Summit criticize the US for having launched quantitative easing? There are two reasons other countries are objecting: (1) Increasing the US money supply will put some downward pressure on the value of the dollar relative to other currencies, which reduces the value of dollar holdings other countries have accumulated, makes it more expensive for US buyers to purchase imports made in other countries, and makes it cheaper for foreign buyers to buy exports made in the US. This means other countries will lose jobs in a situation where everyone is suffering from too much unemployment. Of course if the value of the dollar drops the US will gain whatever jobs other countries lose which we sorely need, and the US does need to reduce our trade deficit. However, the number of jobs moved into the US from abroad by the trade effect of a devaluation of the dollar stemming from this amount of quantitative easing is not likely to be very significant. (2) A more realistic fear is that by lowering interest rates in the US the quantitative easing makes it more likely that short-run financial investment, otherwise known as “hot money,” may flow to other countries where interest rates remain higher. Especially smaller and less developed economies have reason to fear that in absence of controls on the flow of capital between countries this will make them vulnerable again to the destabilizing effects of massive capital inflows that cause unsustainable asset bubbles and inflation, followed by massive outflows that wreak even greater havoc in the form of bankruptcies, recession, or worse. Which brings us to a second subject debated at the Summit.

(2) The South Korean proposal for the G-20 to sanction capital controls. South Korea took advantage of its status as host country for the meetings to propose that the G-20 reverse its long standing position against “capital controls,” which are various programs governments use to limit the size and timing of inflows and outflows of international financial capital. South Korea traditionally practiced capital controls prior to the 1990s when it was pressured to renounce them by the IMF, the WTO, and as a condition for US approval for South Korea to be admitted to the Organization for Economic Cooperation and Development. As a result, South Korea was a victim of contagion in the East Asian financial crisis of 1997-1998 when international investors became suddenly unwilling to refinance short-term loans contracted in hard currencies, there was a run on the won, and a massive capital outflow ensued. While public attention over the past two decades has focused more on other aspects of the neoliberal globalization program pushed by the IMF, WTO, World Bank, and US Treasury Department — such as trade liberalization, privatization, and budget austerity — the most damaging part of the so-called “Washington Consensus” was capital liberalization.

The effects of capital liberalization proved so disastrous that the IMF was finally forced to drop its aggressive campaign for extreme capital liberalization, and adopt a position of limited and temporary tolerance, although there is every reason to believe that if political opposition to capital liberalization weakens the IMF will strike up its campaign again. However, unlike the IMF, the G-20 countries never softened their public stance in favor of capital liberalization, which is particularly favored by the US and the UK. South Korea wanted to get the G-20 in line with the IMF as willing to endorse the usefulness of capital controls in some circumstances, or at a minimum declare that the G-20 countries were officially “agnostic” with regard to capital controls. Moreover, South Korea had good reason to hope for support from other countries such as China, India, and Brazil, all of whom practice capital controls which has helped shield them from international financial crises. Unfortunately, the US and UK seem to have successful tabled this proposal for at least another year.

(3) The US proposal to limit the size of current account deficits or surpluses to less than 4% of GDP. At the last G-20 meetings in Toronto, countries pledged to cut their government budget deficits in half over the next three years. This was a disastrous and counterproductive pledge which can only prolong and deepen the Great Recession. At this summit President Obama proposed that countries include in their communiqué a pledge to work to limit the deficits in their current accounts to less than 4% of GDP. While it is easy to confuse or conflate them, budget deficits and current account deficits, which are essentially trade deficits, are not the same thing at all. A budget deficit is the excess of what a government spends over the tax revenues it collects during a year. A trade deficit is the excess of what a country imports over what the country exports during a year. The degree to which some countries like China and Germany are running large trade surpluses, exporting much more than they are importing, while other countries like the US is importing much more than we are exporting is unsustainable, destabilizing, and needs to be addressed. The real target of this proposal are the Chinese and German trade surpluses. At the moment Germany and China are shielded from the full effects of the global recession on employment by their large trade surpluses, while the severe loss of jobs caused by the Great Recession elsewhere is aggravated by the large German and Chinese trade surpluses. So while the mutual pledge to reduced budget deficits in Toronto was a counterproductive response to the global economic crisis, a mutual pledge to curb trade deficits, but especially surpluses, might well have been helpful.

But of course this was very much a self-serving proposal for the US to make. Not only is the US trade deficit slightly less than 4% of GDP, which means the pledge would not require the US to take any immediate action, reducing the US trade deficit would shift jobs from elsewhere to the US. China and Germany, on the other hand, both have trade surpluses in excess of 4%, so the pledge would require them to act immediately, and by reducing their trade surpluses they would lose jobs — which is something no government should wish to risk while the global economy remains in severe recession. Especially after Obama was politically weakened by the 2010 midterm elections, there was no chance that Germany and China would acquiesce to this proposal which was “Dead On Arrival” before the summit opened.

(4) The US Korea Free Trade Agreement. Billed as a trip to win jobs for Americans at the last minute in the aftermath of the election debacle, Obama was particularly anxious for a photo op signing the US Korea Free Trade Agreement. However, the secret to so-called free trade agreements is that they are also, and often primarily, agreements that liberalize international investment. The truth is that trade liberalization has a minimal affect on jobs. Proponents emphasize jobs added in exporting industries but neglect to mention jobs lost in importing industries. While trade liberalization inevitably creates disruption in labor markets and “structural unemployment” as workers move from one industry to another, in the long-run the net effect on jobs is seldom large one way or another. However, liberalization of investment that is the unadvertised component of agreements that are always described as promoting more free trade invariably lead to significant job losses in the US. Therefore, the fact that Obama could not close the deal on the US Korea Free Trade Agreement was actually a godsend for hard pressed US workers, even if it was yet another political defeat for Obama and his Presidency.

In case you have lost count: This means that nothing significant has been accomplished. Quantitative is easing not likely to accomplish much. At the G-20 Summit there was no new tolerance for capital controls, no agreement to reduce of global macro imbalances, and no new trade agreement. Gridlock and stalemate at the G-20 meetings in Korea, has now followed gridlock and stalemate in Washington due to the 2010 midterm elections, which followed gridlock and stalemate at the Climate Summit in Copenhagen a year ago. There is no movement anywhere toward solving either the greatest ecological crisis humanity has ever faced, or the greatest global economic “falling from grace” since the Great Depression over 80 years ago.

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