Sunday, September 25, 2011

In Praise of Quantitative Easing!

Is quantitative easing the right solution to the problems presently plaguing US and Europe? Are the central banks recreating the loose monetary policies that in part led to the crisis in the first place? What role does monetary policy play in economic growth anyway? Is there a lesson we should learn in India from this?

Before I attempt answering these questions, I must briefly state a story I had read long back about a village where a general sense of gloom is pervading everyone and there is general despondency and pessimism among the villagers. The farmers, the bakers, the wood-cutter and all the rest of them go about their daily work with reluctance and eke out a rather modest living - always wishing they could have more.
One fine day a gentleman from a far off place visits the village goldsmith and tells him that he would like a very beautiful necklace made - for a rather princely sum. The goldsmith agrees and tells the fellow that he can make this masterpiece in a couple of months. The gentleman agrees to return after two months. The goldsmith is rather amazed at his fortune and decides to celebrate by finally ordering that new cart he had been dreaming about all this while. Thus he in turn visits the cart-maker and places an order for the cart. The cart-maker is in turn becomes quite happy with the turn of events and suggests to his wife that they put their presumably bright daughter for private tuition with the maths teacher. The maths teacher decides to stock more grain for her son's wedding and the farmer in turn..... and so on. In the next couple of months, the village is abuzz with a lot of activity and everyone seems to be happier - and most notably, better off!
Unfortunately the gentleman who ordered the necklace perishes in a ghastly accident (the original story did not mention the ghastly accident, I have added it for appealing to the sensationalist within us!!). He thus is not able to collect the necklace nor pay for it. As it turns out though, the village is now quite well-off even without this dosage of income. The goldsmith has other orders to attend and so does everyone.

The above story is an oversimplification but it does carry a very important and powerful message. As much as the economic activity is a function of size and productivity of various resources (capital, labour, land and entrepreneurship) in an economy, in shorter terms, it depends in large measures upon the confidence of various market participants. This can work to everyone's detriment (as it did in the village of earlier) or benefit (as in the village later on). Unlike other market determined inputs, this factor is largely psychological and built on expectations, fears, aspirations and such fuzzy stuff. Hence as much as the purists may hate to bring about subjectivity in their analysis, an economy (especially in turbulence) cannot be properly assessed without these factors.

This is partly what the central banks in the developed world are trying to do. The great depression was in part owing to genuine economic slowdown but was significantly exacerbated due to spiraling effect of the vicious cycle of lower confidence, lower investments, more employment, lower consumption and further lowering of confidence. Ultra-loose monetary policies and massive fiscal stimuli (never thought I would use plural of stimulus in economics!!) of today in the advanced economies are intended to break this vicious circle. In fact the biggest mistake of the then administration during the great depression was a premature belt-tightening by the government - which further depressed economic activity. Japan followed a similar course through its lost decade when it tried to maintain low fiscal deficits in the face of falling economic growth. Unfortunately the political deadlock in the US may force a similar move there as well - though the first dose of fiscal stimulus and still persisting loose monetary policies seem to have successfully averted a depression.

Whats the downside to quantitative easing? To answer that we should revisit the nature of paper currencies and what happens when a central bank prints money recklessly. One can read up on hyperinflation - Poland, Brazil, Zimbabwe all suffered from it in recent decades. Then how is it that US is not seeing any of this?

The answer lies in size and status. All the countries that suffered hyperinflation were trying to print money when the market for their bonds was non-existent (at least outside the home country). There is no use printing money if nobody is going to value it. Another vicious circle can strike such economies when outsiders refuse to convert the currency at any rate and eventually the country simply loses access to outside world - financially speaking. That is clearly not likely to happen to US or the Eurozone. In terms of status, the US occupies a special position as the country that issues the Dollar. That gives it far more leeway in printing more money than a Poland or Brazil.

In summary hence, quantitative easing and loose monetary policy have probably already served their purpose of averting depression. They seemed to have had only partial success though in pump-priming the economies into action through easy credit. That is when the central banking alchemy runs into the genuine problems of indebtedness of the average household and a true lack of the ability to consume as much as they used to till 2007! 

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