The Unnerving Federal Reserve

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The Federal Reserve’s recent announcement that it would purchase up to $600 billion in US debt in order to unfreeze credit markets has raised the hackles of most of the industrialized world. The complaints from Germany, Japan, and especially China regarding the Fed’s second go-around of “quantitative easing” (aka “QE2″) threaten the greenback’s position as the number one reserve currency for the world, and raise the possibility of counter moves from other nations’ central banks to guard against inflation and asset bubbles.

The controversy threatens to make the G-20 conference in Seoul that began Wednesday an exercise in damage control, as most of the industrialized world is nervous about the US recovery and how the devalued dollar might affect its own balance of payments with the US.

If you’re like most of us and found Econ 101 a crashing bore, you can be forgiven for being unfamiliar with quantitative easing and what it’s supposed to do. A nice, simple explanation can be found here. Basically, by way of prestidigitation, the Federal Reserve conjures up a specific amount of money out of thin air — $600 million in this case — and then purchases government and corporate bonds, thus giving banks a boost to their own reserves and, theoretically, making it easier for them to make loans and generate economic activity. Sometimes it doesn’t work at all – especially in uncertain times. Banks are perfectly free to pocket the extra cash and apply it to their reserves, hedging against another downturn. Good for the banks, bad news for the economy.

Quantitative easing is a measure of last resort because the risks of spurring inflation and creating imbalances in some assets are elevated. Other nations with strong export economies like Germany, Japan, and especially China, are worried that the addition to the money supply in the US will further erode the value of the dollar, making US exports more attractive while increasing the price of their own products. This could lead to a trade war — something that will have to be addressed in Seoul. In short, the cure may end up being worse than the disease.

As other nations see it, the dollar is more than just the US’s currency, it is also the world’s reserve currency. This benefits the US economy because the greenback is constantly being propped up by the rest of the world, which doesn’t want to see the value of other currencies plummet. When the Fed takes drastic action, like creating money and pouring it into the financial system of the US, the resulting flood of cash makes central bankers nervous about inflation and governments worried about the export sectors of their own economies.

How long will the dollar be used as the world’s backstop currency? Not very long if China has anything to say about it. Zhou Xiaochuan, head of the People’s Bank of China, set off a wave of unease last year when he almost casually suggested that the world’s financial system could do better if it wasn’t using the dollar as a reserve currency. In a speech last Friday, Zhou revisited that theme:

We can understand the Fed’s QE2 policy, from the angle that it wants to revive the U.S. economy and increase employment. But the problem is the dollar is the global reserve currency…It may not be the right choice for the global economy, though it is a good option for the U.S. economy.

China is, itself, under the gun for its own currency manipulation, but this kind of challenge coming from a nation with an economy the size of China’s will bear watching in Seoul and the months ahead.

China’s jawboning is only the tip of the iceberg. Chancellor Angela Merkel’s Germany has been even more vociferous in opposition to Fed Chairman Ben Bernanke’s QE schemes.

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  • jbtrevor

    Excellent piece!! Even those that (still) hold Obama in high esteem in this country have got to see the connection between Obama's policies and the failed economic recovery in the US, compared to other industrialized nations – the question then becomes "Will they speak up"?

  • ApolloSpeaks

    If at first you don't succeed try failure all over again. QE1, the injection of $1.3 trillion into the economy, was supposed to jump start the recovery and send the GDP soaring. But that hasn't happened. Most companies still aren't hiring and GDP is at a paltry 2% or less. If $1.3 trillion didn't do the trick what can $600 billion (less than half) do? As Bernanke is dealing with an anti-buisness, anti-growth, spread the wealth administration run by an economic ignoramus QE 2 is his last desperate stab at stimulating robust growth.

    Click my name and read my piece "Barack Obama and His Anti-Reagan Destiny," which deals in part with the ominous day Obama reappointed Bernanke Fed chief.

  • Chezwick_Mac

    This decision is purely political…to artificially stimulate the economy by pumping money into it, ancillary repercussions (more debt and rising inflation) be damned. The goal is to improve Obama's prospects for 2012.

  • Gamaliel Isaac

    Obama says that the dollar’s strength rests on a strong economy but printing money does not make a strong economy.

    • InsomniacPrimus

      Depends on whether your idea of strong economy is that of Weimar Germany or modern-day Zimbabwe.

  • InsomniacPrimus

    The expression "The definition of insanity is doing the same thing over and over and expecting different results" comes to mind.

  • Patrick Henry

    This is both a political gambit as well as a lesson in intellectual hubris. Obama's influence at the Fed (or any president for that matter) is indirect (e.g., by appointment and by overlapping interests in restoring the economy, so the gambit is not the president's but Bernanke's. "Helicopter Ben" knows that the Fed is under closer scrutiny than at any time in recent memory. He needs to show that Keynesian counter-cyclical spending can work – its an institutional imperative to secure their place as one of the pillars of the establishment.

    The hubris, the intellectual arrogance, is demonstrated in the belief that managed economies can outsmart the market, but reality cannot be conned forever. Despite ample historical and analytical analysis, how can so many elite policymakers continue to be enthralled by the ideas of long dead economists? Because Keynes and other neo-Marxist progressives found redemption in the idea that one can remake civilization into a just society (i.e., social justice) by tinkering with the lives of its citizens.

  • funny man

    In Germany we automatically appoint 40 million men as assistant head coach once World Cup starts. Of course, everyone knows better than the National Coach. I'm not an expert in fiscal policy but I have my doubts just sitting back and waiting for the "market" to take care of everything is not going to work. The United States lost a significant portion of their former manufacturing basis and that is an inherent weakness that can't be fixed overnight. BTW, that is neither Obama's nor Bush's fault.