By Yilmaz Akyüz
GENEVA, Oct 22 2013 (Columnist Service)

Five years into the crisis, growth in the U.S. is still below potential, Europe is struggling to pull out of recession and major emerging economies are slowing rapidly after an initial resilience during 2010-2011.

Longer-term prospects are not much brighter largely because the key problems that gave rise to the most serious post-war crisis – income inequalities, external imbalances and financial fragilities – remain unabated and have indeed been aggravated.

The world economy suffers from an under-consumption bias because of low and declining share of wages in the gross domestic product (GDP) in all major advanced economies including the U.S., Germany and Japan, as well as China.

Yilmaz Akyuz

Still, until 2008-2009 the threat of global deflation was avoided thanks to consumption binges and property booms driven by credit and asset bubbles, particularly in the U.S. and the European periphery.

The crisis has not removed but reallocated global trade imbalances.

Longer-term global prospects depend a lot on the U.S. due to its central position in the world economy and the international reserves system. It is highly unlikely that the U.S. can move to wage-led growth in the near future.

Nor can it shift to export-led growth. This would require, inter alia, exports to grow faster than domestic demand and the share of private consumption in GDP to fall. This is difficult to achieve since for several decades the U.S. has constantly lived beyond its means thanks to its “exorbitant privilege” as the issuer of the central reserve currency.

Thus, a key question is if the U.S. would be inclined to go back to “business as usual” and allow credit and asset bubbles in search of relatively rapid growth. This is closely connected to its exit from the ultra-expansive monetary policy.

Clearly, exit implies not just increased policy interest rates but also the normalisation of monetary policy – the federal funds rate to become again the main instrument of policy, a significant contraction in the size of the balance of the Federal Reserve (Fed) sheet and the volume of excess reserves that depository institutions hold at the Fed, and a large shift of the Fed’s asset composition back to short- and medium-term Treasuries.

A strategy that the Fed should gradually exit from the quantitative easing (QE) 3 but maintain low policy rates for several more years in order to support growth and use macro-prudential regulations to limit systemic risks appears to be enjoying considerable support.

However, it may not be easy to engineer such a process without jeopardising financial and macroeconomic stability. Uncertainty abounds because there are not many historical precedents for exit from extended periods of zero-bound interest rates and QE.

Even a gradual return of the Fed balance sheet to “normal” size and composition may result in a considerable hike in long-term rates even if policy rates are kept low for an extended period. The prospects for exit from the QE3 in the coming months have already pushed up the yield on the U.S. 10-year Treasury bond to almost 3 percent in August 2013 from around 1.60 percent in May.

If concerns about financial instability and the effectiveness of macro-prudential measures come to dominate, the Fed may be obliged to exit rapidly. This would result in a hike in short- and long-term interest rates and give a major shock to the financial system as in 1994.

It would result in slower growth and a stronger dollar. Too rapid an exit and re-pricing of substantially increased stock of debt could even cause a hard landing in the U.S. by leading to large losses for bondholders and depressing private spending.

These dilemmas arise in large part because of excessive reliance on monetary policy to combat recession and the reluctance to use fiscal expansion and debt restructuring to stimulate aggregate demand.

The normalisation of monetary policy in the U.S. will also cause problems for emerging economies. Despite occasional complaints about the “currency war” entailed by liquidity expansion in several major advanced economies simultaneously, the policy of ultra-easy money has generally been benign for emerging economies.

It has been a major factor in the sharp recovery of capital inflows after the sudden stop caused by the Lehman Bank collapse in September 2008.

Many major emerging economies such as India, Brazil, South Africa and Turkey have come to depend on such inflows as their current accounts started to deteriorate. They have invariably welcomed the asset bubbles that such inflows have helped generate and often ignored the financial fragilities caused by increased exposure to interest rate and exchange rate risks by private borrowers abroad.

Such exposures are on the rise since the beginning of 2012. As funds have started to be withdrawn from domestic securities markets, emerging economies have increasingly relied on international debt contracted in reserve currencies, which reached, in net amounts, 600 billion dollars between the beginning of 2012 and mid-2013.

As the Fed has got closer to ending the QE3 and the long-term U.S. rates have edged up, strong downward pressures have started to build up on the currencies, stocks and bonds of several emerging economies such as Brazil, India, South Africa and Turkey, which were widely seen as rising stars only a couple of years ago.

And the longer-term prospects of the eurozone are even less encouraging than the situation in the U.S. Deleveraging and recovery are likely to remain extremely slow in the periphery and many countries cannot expect to recuperate the output losses incurred after 2008 for several years to come.
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Quantitative Easing (QE) has been favourable to developed countries, stimulating local investment and exports. Credit: Bigstock.

By Fernando J. Cardim de Carvalho
RIO DE JANEIRO , Jun 25 2013 (IPS)

It took world leaders some time to realise that the financial crisis initiated by the collapse of the subprime mortgage segment of U.S. financial markets in 2007 would not exhaust its effects in an ordinary recession.

For most of 2007 and 2008, government authorities, especially in the U.S., argued, rightly, that subprime mortgages were a relatively small segment of the U.S. financial system, concluding – wrongly, as it turned out – that the crisis could be easily contained through the use of conventional policy instruments at the disposal of the Treasury and the Federal Reserve.

In fact, the crisis spread out to other segments of U.S. financial markets and, in September 2008, with the bankruptcy of Lehman Brothers, it spread out to most of the rest of the world.

As domestic financial sectors in the countries hit by the shock waves were engulfed by their own crises, credit supply contracted and the financial crisis was transformed into an economic crisis, with falling output and rising unemployment.

The realisation that the crisis was deeper than most analysts expected initially led governments to react through implementation of anti-cyclical macroeconomic policies. Expansive fiscal and monetary policies were implemented, in one form or another, not only in the U.S. and Western European countries, but also in many developing economies in 2008 and early 2009.

The collapse of output and employment in the developed economies was contained and the ghost of a disaster like that of the early 1930s was, at least temporarily and at least for some countries, exorcised.

At this point, economic policy debates in the richest economies suffered a reversal.

Output was still lower and unemployment much higher than before the crisis both in the U.S. and in Europe. Nevertheless, the debate switched from real problems to fiscal balances. Conservative groups, ranging from the lunatic extreme right of the Tea Party in the U.S. to the moralising posture of northern European governments led by right wing parties or coalitions, prevented the further use of fiscal policy to raise output and to create jobs.

It is a fascinating discussion as to why this happened, but there is no room in this commentary to explore the question. The fact is that aggressive expansionary fiscal policies have become politically unacceptable even while output is low (or even falling, as is the case with many European countries, and not only the “peripheral” ones) and unemployment is growing. Under these conditions, the only instrument left to try to increase market demand and to stimulate production was monetary policy.

Monetary policy, traditionally, impacts the economy through variations of interest rates. The interest rates under the control of monetary authorities like the U.S. Federal Reserve or the Bank of England, for instance, were, however, already very low, near zero.

There was not much conventional monetary policy could do to compensate for the lack of a rational expansionary fiscal policy. It was in this context that quantitative easing (QE) policies were formulated in the U.S., U.K. and more recently in Japan, while the European Central Bank struggles with itself to determine what should be its policy. QE policies are simply initiatives to funnel money into the economy in amounts great enough to facilitate the expansion of the supply of credit for private borrowers, both firms and consumers.

It may be too soon to assess whether they worked as expected or not. Of course, the developed economies where these policies were implemented are still struggling with the crisis and its developments. A generous reading of these policies is often based on a counter-factual: things are not that good yet, but they would be much worse if those policies had not been applied.

For developing economies, the impact is certainly ambiguous. On the one hand, accepting the assumption that without QE policies developed countries would be in a much worse situation than they are now, it is better than nothing.

If output had contracted further in those economies, trade would be even lower nowadays, creating balance of payments problems for many developing countries.

On the other hand, from the point of view of developing countries, monetary easing is certainly not the ideal way to support output and employment.

QE increases money supply at the same time that it reduces domestic interest rates in the developed economies. In a world of free capital flows, as is mostly the case now, this means that a large part of this liquidity will flow out of the country that created it.

In part, although governments deny it, this is precisely what they expect: capital outflows devaluate the currency of the country practicing QE, so it will have two stimuli for the price of one: lower interest rates stimulate domestic production and investment, and devalued currencies stimulate exports.

Of course, for developing countries the impact is exactly the opposite: they receive too much foreign liquidity, their exchange rates tend to become overvalued, reducing exports and stimulating imports.

Deficits in the balance-of-payments current account tend to emerge, but it is easy to finance them since there is so much liquidity in the world.

Until, of course, QEs are discontinued and borrowing countries will find out, as they did many times in the past, that foreign debt accumulated to the point of leading them to a crisis.

Would it be better not to have developed countries practicing QE? Well, governments in these countries had to do something and monetary policy was the only instrument left after right wing parties prevented them from using fiscal policy.

Expansionary fiscal policies in those countries, however, would be much better for developing economies because they expand their domestic economies without undervaluing their currencies. Fiscal expansion, in contrast to monetary expansion, is not a beggar-thy-neighbour type of policy.

There is evidence now that the Federal Reserve expects to stop QE3 relatively soon. QE had some deleterious impacts on developing countries, as just argued, but its reversal is also full of risks.

It is possible that interest rates will rise too much and too quickly, creating serious problems for those countries and firms that borrowed more in this period.

Increased volatility itself, because of the uncertainties such a change in direction engender, is a problem, scaring investors and depressing production and investment. To expand the economy to get out of a depression is the correct attitude, but QE was an instrument that definitely contributed to increased short and medium term risks of the macroeconomic situation.

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The New York Stock Exchange, as seen from the boot of George Washington’s statue at Federal Hall. Credit: Dan Nguyen/CC-BY-2.0

By Shyam Saran
NEW DELHI, Jun 5 2013 (IPS)

The global economy is awash with successive waves of liquidity generated over the past few years by the four most advanced economies, viz., the United States, the European Union, (EU), Japan and the United Kingdom, known as the G4. This liquidity has taken the form of “quantitative easing” (QE).

When zero rates of interest have failed to stimulate their economies, these countries have resorted to large-scale asset purchases by their central banks, such as corporate bonds or mortgage backed securities, to pump more money into the banking system.

The aim is to extend credit to business and industry and encourage consumption.

In the immediate aftermath of the global financial and economic crisis in 2008, when there was a danger of financial collapse, both advanced as well as emerging economies adopted stimulus packages, to revive demand, maintain trade flows and avoid large-scale unemployment. During the crisis phase of 2008/09, QE played an important role in crisis management, helping advanced and emerging economies alike.

However, while emerging economies have weathered the crisis and seen a revival of growth, the G4 continue to experience economic stagnation, depressed markets and large-scale unemployment.

Their response has been to persist with even larger doses of QE as a means of propping up demand,encouraging banks to expand and boosting stock valuations.

Before the crisis, the U.S. held 700 to 800 billion dollars of Treasury notes. The current level is 2.054 trillion dollars. In the latest round, QE-3, the U.S. Federal Bank is committed to the purchase of 40 billion dollars of mortgage-backed securities per month as long as unemployment remains above 6.5 percent.

The European Central Bank (ECB) has pumped 489 billion euros of liquidity into the eurozone since the crisis, while in the United Kingdom QE has reached the level of 375 billion pounds.

Most recently, the Bank of Japan has decided to pump 1.4 trillion dollars in the next two years into its economy, aiming at a two-percent inflation rate by doubling the money supply.

The assets of the G4 central banks have expanded from a figure of 11-12 percent of their gross domestic product (GDP) to the current unprecedented level of 23 percent. These assets were 3.5 trillion dollars in 2007 before the crisis. They are now nine trillion dollars and rising. This is the scale of liquidity expansion we are dealing with.

Since interest rates in the G4 remain at zero and their economies remain stagnant, it is inevitable that there will be significant capital outflows to emerging and other developing economies, in quest of higher risk-adjusted returns.

According to one estimate, about 40 percent of the increase in the U.S. monetary base in the QE-1 phase leaked out in the form of increased gross capital outflows, while in the QE-2 phase, it may have been about one-third.

This massive and continuing surge of capital outflows to emerging and other developing economies is having a major impact. Corporations, which have a sound credit rating, are taking on more debt, and increasing their foreign exchange exposure, attracted by low borrowing costs.

Their vulnerability to future interest rate changes in the developed world and exchange rate volatility will increase. Such inflows put upward pressure on exchange rates, stimulate credit expansion, and cause inflationary pressures, which pose a major challenge to policy-makers in the developing world.

Most of the capital inflows are in the nature of portfolio investments, which are prone to sudden and volatile movement and puts emerging economies at greater risk. The volatility one has witnessed in the Indian stock market is a case in point. In general, we may conclude that the overall impact of these capital flows is expansionary and distortionary.

There has been considerable criticism of the G4’s unconventional monetary policies from the emerging economies, including the BRICS (Brazil, Russia, India, China and South Africa).

The magnitude of QE has had unintended consequences beyond the borders of the G4, especially because their currencies are not only fully convertible but, together, constitute the pillars of the global financial system.

The U.S. dollar is the world’s leading reserve currency, and the euro, the British pound and the Japanese yen together constitute the basket of currencies the International Monetary Fund (IMF) uses to value its Special Drawing Rights. Thus, the nature of the G4 currencies and their significant role in the global financial market ensures that QE undertaken by them has a global impact on economies across our globalised and interconnected world.

It is necessary, therefore, for the G4 to act with great responsibility and to work together with the emerging economies, to minimise the adverse effects of their QE policies. It would be particularly important to forge a consensus on how to handle the potential financial turmoil and disruption that may afflict developing economies once the QE is sought to be retired and interest rates once again become positive in the G4. The sudden and large-scale reversal of capital flows is a likely scenario that would need to be anticipated and managed.

The Asian financial crisis of 1997/98 was, in part, triggered by an earlier version of QE pursued by Japan in the aftermath of the bursting of its property and asset bubble in the early 1990s. Then, too, the large inflow of low-cost yen loans led to the asset price bubbles, inflationary pressures and currency instability in the Asian economies. They paid a heavy price in the bargain.

A larger, more pervasive crisis may await the emerging and developing economies unless there is a much more coordinated and careful handling of the risks that are already building up. The G20 should have this issue at the top of its agenda.

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