What Impact Will Monetary Easing Have on U.S. & Global Economies?

February 3, 2011

Brian Foran, Managing Director, Equity Research Sector Head covering Banks, Nomura Securities International, Inc.
Alicia Ogawa, Senior Advisor, Center on Japanese Economy and Business, Columbia Business School, Adjunct Associate Professor, School of International and Public Affairs, Columbia University
David Resler, Managing Director, Chief Economist U.S., Nomura Securities International, Inc.
Gillian Tett, U.S. Managing Editor, The Financial Times

Sara Eisen, Reporter and co-host of “Bloomberg on the Economy” on Bloomberg Radio


A distinguished panel of experts on financial markets gathered at Japan Society to discuss the Fed's second quantitative easing program, known as QE2.


Moderator Sara Eisen of Bloomberg posed a series of questions:


Why did the Fed implement QE2?


David Resler of Nomura explained that by mid-2010, Fed officials had two growing worries: that the U.S. was about to take a second dip into recession, and that we were heading towards "a deflationary environment." The core CPI in fact hit an all-time low in October 2010; the first purchases under QE2 were made in early November.


Given its two aims, averting a W-shaped recession and guarding against deflation, "I think it's undeniable that the Fed has succeeded in accomplishing that mission," he added.


The Fed's QE2 is being compared with the steps taken by the Bank of Japan to deal with deflation. Are these parallels rightly drawn?


Many criticize the Bank of Japan (BOJ) for having done too little too late, Alicia Ogawa of Columbia said. However, the BOJ has been "very, very bold in trying new policies that have never been tried before." It was the first to commit to a long-term zero interest rate policy. It has "a very aggressive" program to buy stocks from commercial banks, as well as programs to buy ETFs, commercial paper, corporate bonds, and REITs and to support bank loans to new-economy companies.


The Japanese economy has "any number of rigidities" that impede the process of creative destruction, Professor Ogawa said. Banks go on lending to unproductive "zombie companies." Japanese companies, like American ones, try to deleverage by cutting salaries and laying off workers rather than by building up revenues. "This has created a kind of permanent underclass of people who will never be permanent employees, will never be white-collar employees with all the social consequences that implies."


In Japan as in the U.S., the focus is on services to the elderly, Medicare, Social Security and not on "investing in education for the young," Professor Ogawa said. The Japanese seniority system keeps new people and new ideas out of both the corporate world and the political world.


The nature of the JGB market creates problems specific to Japan. "The fact that virtually all JGBs are held domestically alleviates the pressure on the government to perform fiscal discipline. This means also that there is no real rate of borrowing or lending. It's a confusion in financial markets. What is a triple-A company credit risk worth versus somebody who is a triple-B?"


Tell us about the knock-on effects from QE2, the very low interest rates for the banks.


The very low rates are "bad for bank margins, good for housing values and good for consumer cash flow," Brian Foran of Nomura said.


Banks typically pay interest to depositors at around 100 basis points below Fed funds, and can then park the deposits overnight with the Fed and earn 100 basis points risk free. When the Fed funds rate is at zero, the banks have nowhere to go. They can't pay depositors less than zero.


With interest rates low, housing looks cheap. The median mortgage payment is 18 or 19 percent of median income—lower than the norm, which is in the low to mid-twenties, and way below the 2006 peak of 30 percent.


In terms of cash flow, American consumers who find themselves in a negative equity situation, as do a quarter of Americans who have mortgages on their homes, choose to pay down debt—even though the textbook rule says that "when money is cheap, you should borrow a lot of it," Mr. Foran said. Thus despite record highs in the debt-to-income ratio, "the debt service burden for consumers is below the 30-year average, and still headed lower."


In the U.S., bank losses will be about 12 or 13 percent, "somewhat comparable" to the Japanese banks' losses of about 17 percent cumulatively over a 10-year period. But U.S. banks started out with twice the capital, as well as greater earning power, which "has made the policy response of the U.S. a little bit more manageable. Something like the stress test was feasible in 2009 in the U.S. in a way that it would not have been in 1997 for the Japanese banks."


How do central bankers and policymakers abroad view the effect of quantitative easing in the U.S.?


Gillian Tett of The Financial Times replied, "Under many measures, you can argue that [QE2] has worked already, because a deep recession has been staved off." However, "right now, I think the future of that is pretty uncertain."


Countries abroad worry about exchange rate pressures—a number have imposed "quasi capital controls"—and about inflation pressures and the future of the dollar. There's a widely shared belief "that yet again, America is refusing to bite the bullet of the badly needed adjustment," trying "to stave off the bust, stave off the day of reckoning through various forms of easy policy."


What are the domestic political ramifications of QE that could have an impact on the Fed's actions down the road?


"This more subtle concern that the U.S. is failing to deal with its long-range problems is a theme that's very important in the Tea Party dialogue," as exemplified in Rick Santelli's remarks on CNBC, Dr. Resler said.


"In the face of the financial crisis, I think it's interesting that we're seeing kind of this revival of the Austrian tradition in economics," he added. "I'm not totally persuaded that what we're doing is in fact superior to biting the bullet, but I'm pretty sure that biting the bullet would be pretty devastating in the very short run. In the long run it might be much better, but that's a long run we're probably not going to see happen in that fashion."


"The UK right now is embarking on a strategy of trying to bite the bullet," which makes the current dilemmas "the most fascinating laboratory test case in how to respond to a slump," Dr. Tett said. "Quantitative easing, if you will, is a sugar coating on the pill of the need to actually get serious about drawing up proactive fiscal plans. The danger is that everyone keeps sucking the sugar and doesn't ever actually take the pill."


"This is actually what has gone on in Japan for the last 25 years," Professor Ogawa commented. The Bank of Japan has been saying to the LDP, and now to the DPJ, "'you're spending money like drunken sailors on bridges that go to nowhere, and Shinkansen that go to places that have 10 people living there, and we're not going to take the risk of debasing the currency and fostering mega-inflation unless you politicians put the budget in order.' And that's exactly what's happening in America, and that's why you have this debate about independence of the Fed, and independence of the Bank of Japan, and should we adopt inflation targeting, which is pretty much politically motivated, should we adopt price targeting and so on."


The differences between the UK and U.S. approaches reflect contrasting political structures, Dr. Tett added. The UK has five-year terms, whereas American elections are a "two-year merry-go-round." The UK is basically run by a very small group. And "we have Greece and Ireland on our doorsteps showing the population very clearly why we need to act."


The government debt to GDP ratio in Japan is 200 percent, and in the U.S. close to 100 percent. Plenty of bond investors and economists say these are ticking time bombs. Are we and Japan protected from a Greek-style crisis, in that we have the dollars and Japan has the savers?


The crisis in Greece "really was the catalyst to getting some serious talk in the Diet about cutting expenses," said Professor Ogawa.


As the population ages and baby boomers start to retire, "the savings rate in Japan has now dipped below that of the U.S." There's "a broad consensus in Japan that this situation is unsustainable. And the S&P downgrade of the sovereign debt was a rude shock."


"But the political system is frozen, it's dysfunctional. Nobody knows what to do about it," she said. Regardless, "the minute that Japan has to start borrowing overseas, you will see interest rates just hit the roof."


Dr. Tett said that when she ran the Financial Times Tokyo bureau during the late 1990s there were long conversations with visiting U.S. officials on why Japan hadn't managed to create rational plans to end the banking crisis and deal with toxic assets.


"There were beliefs, somewhat naively, that the American political system was better suited to coming out with sensible answers. But I think, if nothing else, the last few years have punctured much of that complacency or arrogance and shown that ironically so many of the conversations we were having in Tokyo back in 1997, '98, '99 can now be applied unfortunately to Washington too."


What would an age of austerity in America mean for the biggest financial institutions?


"It would be terrible," Mr. Foran responded. "If you have deflation, you have shrinking income, shrinking asset values. Something like 60 percent of the banking system is tied to real estate. If the borrower has less income and the asset has less value, you're going to lose more money on the loan. So, inflation is a vastly more palatable outcome for the banking system than deflation."


Fifteen years ago, "the amount of capital it would have taken to recapitalize the Japanese banking system seemed so daunting," and now the U.S. has put together "a playbook from scratch on how to do that."


Audience members joined in the Q&A:


What can we be optimistic about, despite this picture of overwhelming pessimism?


Progress in the housing finance market is one positive sign, Dr. Resler said. There's evidence of greater confidence among investors and business people, and "a new sobriety that has hit the American people," an understanding that we can't fund all the social welfare promises that our leaders made in the past.


Except for Fannie Mae and Freddie Mac—admittedly big exceptions—"the government really doesn't have to backstop any bank's debt anymore," which "is phenomenally positive," Mr. Foran commented.


Political parties are changing in Japan; the LDP is out of power, and in the DPJ, the 40- and 45-year-olds who are just below the senior-most level and have been educated abroad "are very sharp," Professor Ogawa said. The transition is "going to be very painful, but I think there is a new Japan somewhere out there on the horizon."


Dr. Tett said she finds "a newfound cynicism about finance and banks," as well as "a new awareness on the global scene about just how dangerous and potentially unsustainable some of the global imbalances are." The energy and determination of entrepreneurs are "very impressive, and that has got to be the best source of optimism about the future."


Will there be a QE3 after QE2?


In reality we're already in QE3 or QE4, Dr. Resler said. This will be the last phase. Political support is waning; moreover, "the Fed needed to convince a skeptical market that it was prepared to do whatever was necessary to prevent deflation. It was really a psychological war that it was waging, and I think it won that psychological war."


Katherine Hyde

Topics:  Business, Policy

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