The Fed risks fueling a destructive bond market bubble, while any gains from a weaker dollar will come at the expense of those to whom we hope to export.
By JOSEPH STIGLITZ
The Federal Reserve, having done so much to create the problems in which the economy is now mired, having mistakenly thought that even after the housing bubble burst the problems were contained, and having underestimated the severity of the problem, now wants to make a contribution to preventing the economy from sinking into a Japanese-style malaise. How? As Chairman Ben Bernanke announced last week, through large-scale purchases of U.S. Treasurys—called quantitative easing, or QE.
The Fed is right to be worried.
If high unemployment continues, America faces the risk of losing human capital as the skills of the unemployed erode. It will then become increasingly difficult to bring the unemployment rate down to anywhere near the levels that prevailed in the mid- and late 1990s, and the higher unemployment rate and lower output will make the current pessimistic budget projections of the Congressional Budget Office and the Office of Management and Budget look rosy.
The problem is that, with interest rates already near zero, there is little the Fed can do to restart the economy—and doing the wrong thing can do considerable damage. In 2001, (then) record-low interest rates didn't reignite investment in plant and equipment. They did, however, replace the tech bubble with an even more dangerous housing bubble. We are now dealing with the legacy of that bubble, with excess capacity in real estate and excess leverage in households.
U.S. Federal Reserve Chairman Ben Bernanke
Today, the Fed is paying too little attention to the transmission between the interest rates paid by government and the terms and availability of credit to small and medium-sized enterprises (SMEs). Large businesses are flush with cash, and small changes in interest rates—short-term or long—will affect them little. A banker rightly asks if such a business comes asking for money, "What's wrong with it?"
But it is SMEs that are the source of job creation in most economies, including the U.S. Many of these enterprises are starved for cash. They can't borrow money at the interest rate that big banks, big firms or government can. They borrow from banks, and many of the smaller local and community banks on which they depend are in dire straits—more than 800 are on the FDIC's watch list.
Yet even if the banks were willing and able to lend, lending to SMEs is typically collateral-based, and the value of the most common form of collateral, real estate, has fallen 30% to 40%. No wonder then that credit availability is so constrained. But QE in the form of buying U.S. Treasurys is not likely to affect this much. It will have some effect in lowering mortgage rates, and lower mortgage rates will put a little more money into people's pockets. Higher real-estate prices may also allow some SMEs to borrow more. But these effects, though positive, are likely to be small—so small as to make a barely perceptible difference in America's persistent unemployment.
There is another channel through which easing will have some positive effects: Equity prices are likely to rise. But for all the reasons just given, this is unlikely to have much effect on investment. Nor will most Americans, burdened with debt and diminished retirement accounts, likely embark on much of a spending spree. Nor should they. Doing so would only delay the deleveraging that is necessary if we are to have sustainable growth going forward.
There is another downside risk: QE may not even succeed in lowering interest rates, or lowering them very much. Given the magnitude of excess capacity, there is little risk of inflation today. But if the inflation hawks come to believe that the risk of future inflation is real, then they'll believe that short-term interest rates will rise. This will mean that long-term interest rates, even now, may actually rise, in spite of the massive Fed intervention, because long-term interest rates are based on expectations of future short-term interest rates.
QE poses a third risk: The bursting of the bond market bubble that the Fed is seeking to develop—the sequel to the tech and housing bubbles—will clearly have adverse effects on the economy, as we should have learned by now.
The advocates of QE point to another channel through which it will strengthen the economy: Lower interest rates may also lead to a weaker dollar, and the weaker dollar to more exports. Competitive devaluation engineered through low interest rates has become the preferred form of beggar-thy-neighbor policies in the 21st century. But this policy only works if other countries don't respond. They will and have, through every instrument at their disposal. They too can lower interest rates. They can impose capital controls, taxes and bank regulations, and they can intervene directly in their exchange rate.
Under the gold standard, there was supposed to be an automatic adjustment mechanism, as a country with a trade surplus would see an inflow of gold and an increase in prices, leading to an automatic real appreciation of its currency. It never worked as smoothly as it was supposed to, but in the modern economy with fiat money, the adjustment processes can be short-circuited even more easily. China, for instance, has sufficient control of its banking system and economy that it can simultaneously maintain a stable exchange rate that generates a surplus and prevents inflation.
Such policies may come with a price, but the price may be less than the alternative: the bankruptcies and unemployment that would follow from disruptive currency appreciation as the U.S. lets forth a flood of liquidity. That money is supposed to reignite the American economy but instead goes around the world looking for economies that actually seem to be functioning well and wreaking havoc there.
The upside of QE is limited. The money simply won't go to where it's needed, and the wealth effects are too small. The downside is a risk of global volatility, a currency war, and a global financial market that is increasingly fragmented and distorted. If the U.S. wins the battle of competitive devaluation, it may prove to be a pyrrhic victory, as our gains come at the expense of others—including those to whom we hope to export.
Mr. Stiglitz, a Columbia professor, won the 2001 Nobel Prize in economics. The paperback version of his book "Freefall" is just out by W.W. Norton.
