The Fed’s Gamble Threatens World Economy

The Federal Reserve has just proposed what has come to be called QE2 (QE for “quantitative easing”). It’s not the kind of proposal that rewards everyone with a trip on a luxury cruise liner but an injection of the order of $600 billion into the economy in the form of purchases of American treasury bonds from investors. From Beijing to Brasilia, this measure has been criticized as threatening the world economy.

First of all, this measure will have an impact on international markets: in an earlier post, I had already criticized the [US] Treasury’s proposals aimed at requiring each country’s balance of payment deficits to remain within a “corridor” of plus or minus four percent of GDP. The Chinese have already let it be known that this is out of the question. In addition, such a measure is impossible to put into practice.

This new measure will have an immediate impact: a lower dollar. The injection of liquid assets will in fact keep American interest rates at an indecently low level. They will no longer cover the risk premium that investors require from an over-indebted country.

The aim of this measure is to stimulate the economy and revive employment. But the United States suffers from structural economic problems. Contrary to what one might expect, direct investments in the United States are negative, of the order of $200 billion. That is to say, foreign investors have “repatriated” their investments in the United States that are no longer viewed as productive, given the structural problems of the American economy.

In terms of financial investments, there is also a risk that the situation will deteriorate. In search of higher yields, investors will be led to buy junk (high-risk) bonds. The risk profile of financial markets will thus deteriorate. It will be the same for the banks who will, once again, become weakened.

While companies will be able to finance themselves on the capital markets at advantageous rates, this sector is not a net borrower at the moment: it issues obligations and reimburses banks. This means, in blunt terms, that the economy may not receive any stimulus at all. Paul Volcker has just pointed out to a forum in Seoul that, at the current level of American interest rates, such an injection of liquidity will not be effective. At least two governors of the Federal Reserve are in disagreement with their chairman.

As I pointed out before the renewal of the term of office of Ben Bernanke as chairman of the Fed, that decision is proving to be a bad one. One doesn’t renominate as captain of the Titanic the person who led the ship into an iceberg. The measures announced [by the Fed] are not well received because of their substance, but all commentators remind us that Ben Bernanke didn’t see anything coming.

In contrast, the European Central Bank is maintaining its course: this will not fail to make European businesses howl about their problems of remaining competitive. It should absolutely maintain its course if we wish to avoid a rapid rise in inflation. It is here that Europe should, in a unanimous manner, adopt an extremely hard line vis-à-vis the U.S. administration at the G20.

American irresponsibility threatens the world economy. In view of its size, the Federal Reserve, as Pierre-Antoine Delhommais wrote in Le Monde, “is our central bank and your problem.” For all of the advantages that the United States derives from its dominant position, it also has responsibilities. In one week, two measures have highlighted the international irresponsibility of the American authorities. Their silence these past days has been deafening.

Ben Bernanke is betting that these measures will not create inflation; in theory, utilizing such “pump priming” has inflationary effects. He may well be right, but the rest of the world should be wary; developing countries in particular, with whom Europe would do well to adopt a united front.

An international consensus will not forestall the American measures, but it will put the United States on the defensive at the G20. It is once again playing roulette with the world economy, and it could well, yet again, be at the origin of the next crisis.