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QE2 could becomeTitanic2
Howard Richman, 11/14/2010

“QE2” are the initials of the Queen Elizabeth 2, a great ocean liner which was the sequel of a great ocean liner. They are also the initials of “Quantitative Easing 2,”  Federal Reserve Chairman Ben Bernanke’s second huge increase in the United States money supply. Although QE1 was a huge success, QE2 could end in disaster. If so, it may be renamed “Titanic2,” after another ocean liner, one that sank. 

QE1 restored liquidity to the U.S. money supply during and after the October 2008 financial crash.  The extra liquidity provided by the Fed let American banks lend short term so that businesses could meet payrolls and buy inventory. As part of the QE1 package, Bernanke even made currency swaps with fellow central banks, which made dollars available around the world to foreign businesses whose debt payments required dollars. QE1 was Bernanke at his best.

QE2 is designed to reduce American private savings and also to cause private foreign savings to flee from the United States. Its goal is to increase inflation from its current 1% to at least 2% or 3% while keeping short-term U.S. interest rates close to 0%, producing an “inflation tax” upon private American and foreign savers.

Bernanke hopes that reducing private American savings will increase American consumption and that sending private savings abroad will improve America’s trade balance. Indeed, the short-term result of QE2 will be beneficial. Consumption will increase and private savings will flee the country for better interest rates abroad. Already, the dollar has weakened versus most foreign currencies, which makes American products more competitive in U.S. and world markets.

But in the long term, Bernanke’s discouragement of American savings will reduce investment in America’s economic future and his decision to increase inflation will provide a new element of uncertainty in business decision making.

The effect upon the dollar can’t help much. It will either be temporary or disastrous, depending upon what foreign central banks do:

1. Temporary Effect. If foreign central banks buy dollars with their currencies to prop up the dollar, as most Asian central banks are already doing so that their own products will be more competitive, they will drive the dollar back up, eliminating the positive effect upon America’s trade balance.
2. Disastrous Effect. If foreign central banks don’t buy dollars, then the dollar will collapse, producing a severe cut in American living standards. The United States would experience inflation. Interest rates would skyrocket. The prices of foreign goods, including oil, would skyrocket.

QE2 is a sign of desperation. Bernanke would not risk a dollar crash if he thought that he had any other choice. But all of the major economic philosophies have been failing in recent U.S. economic history because of our failure to balance trade:

1. Monetarism Failed. Alan Greenspan was an excellent Federal Reserve Chairman in that, unlike Bernanke, he kept the U.S. money supply growing on an even keel. But his failure to stem the foreign savings being forced into our economy by foreign governments that were seeking trade surpluses fed the house price bubble with low interest loans. The 2006 collapse of the house price bubble, in turn, started the Great Recession. Greenspan didn’t understand that economic stability requires balanced trade.
2. Supply Side Economics Failed. President GW Bush’s attempt to grow the economy through huge tax cuts failed because he let the Asian governments manipulate the dollar’s exchange rate in order to keep their labor costs low to steal our industries. If he had required balanced trade, American businesses would have invested their profits in American factories. American workers who lost their jobs to imports would have taken even better paying jobs producing exports. Instead Bush presided over a decline in American median income.
3. Keynesian Economics Failed. President Obama’s attempt to grow the economy through huge stimulus packages failed. An analysis of the data of the last two quarters shows why. During the second quarter, Obama’s “summer of recovery,” the growing trade deficit reduced economic growth from 5.1% to just 1.7%. During the third quarter it reduced growth from 4.0% to 2.0% (according to preliminary data). Our naïve president has relied upon diplomacy to change China’s policy. His failure at the G-20 last weekend shows that he is never going to be able to talk China into changing.

There has always been, and there will always be a way for a country with a huge trade deficit to get its economy moving. All it needs to do is balance trade. Doing so would provide an economic stimulus with legs. American consumption would increase because American demand would be producing American income, not Chinese income. American business investment would increase because businesses would be able to produce goods in the United States and still sell in China.

There is a very simple way to balance trade, a scaled tariff whose rate goes up as our trade deficit with a particular country goes up, down when the trade deficit goes down, and disappears when our trade deficit disappears. Such a WTO-legal tariff would force the trade-manipulating governments to take down their many, many barriers to American products, increasing American exports while decreasing American imports.

There are three pillars of economic stability: balanced monetary growth, balanced budgets and balanced trade. At the moment, the American establishment is not doing any of them. The result could be catastrophic.