Financial markets may be cheering on US Fed Reserve boss Ben Bernanke as he gets set to unleash a fresh round of monetary stimulus, but some are worried that his actions will further jeopardise the reputation of the US central bank, along with its future independence.

The latest newsletter from Hoisington Investment Management makes a convincing case that the enthusiasm for a fresh round of quantitative easing — dubbed QE2 by the markets — is a classic case of flawed thinking.

The authors of the newsletter — Lacy Hunt and Van Hoisington — argue that previous monetary and fiscal policies have failed to spark a sustained economic recovery. Despite extreme measures, real GDP has only climbed by a “paltry” 3% since the recession ended in June 2009, well below the 6.6% average growth recorded in comparable periods in the previous 10 recoveries.

In fact, US economic growth — measured by real final sales — is barely managing to keep up with the country’s population growth. Real final sales in the current rebound have only climbed by 0.2%, which is much lower than the previous 10 recoveries, when the growth in real per capita sales was a much more robust 3.2%.

“Thus, the US standard of living has remained stagnant at a very depressed level.”

As a result, US policy-makers are under huge pressure to introduce new fiscal and monetary policies to stimulate growth. But the authors argue that these new measures may not prove any more successful than their previous attempts. Even worse, they may prove extremely harmful.

The authors argue that the US Fed Reserve’s forecasts about the economic recovery — which assumed that massive government deficit spending and aggressive monetary stimulus would boost growth — have turned out to be flawed, and have had to be revised down. Surprised by the weakness in the economy, the US central bank is contemplating QE2, even though the problems in the economy are not related to monetary policy.

“The Fed’s position seems to be that more of the same economic policies are needed, even though they have failed to produce the advertised results,” the authors argue.

The pair add that there are huge amounts of liquidity in the US financial system. As a result of QE1, banks hold close to $1 trillion in reserves. But the banks don’t want to lend these reserves either because they don’t want to put additional capital at risk because their balance sheets are already too shaky, or because they face large write-offs on problem loans, particularly in commercial and residential property. Another reason may be that the banks don’t believe their customers have the capacity to take on additional debt.

Similarly, non-bank corporations are sitting on massive cash reserves. For the past six months, liquid assets have accounted for 7% of total assets, the highest level since 1963. But, the authors note, companies have clearly decided there aren’t too many compelling uses for these funds, and they may also be using the case to hedge against risks.

“The fact that substantial bank and corporate funds remain idle is a strong signal that US economic problems exist outside the monetary sphere.”

So what will be the impact of QE2?

The authors point out that the most likely outcome is that it fails to boost economic activity: “It should be clear that QE2 and the purchases of additional assets by the Fed will, like previous purchases in QE1, serve only to bloat excess reserves without advancing income, spending, or jobs.”

They argue that the only way that QE2 will work is if succeeds in triggering a new cycle of borrowing and lending, which would result in even more Ponzi-style debt being piled onto an already overleveraged economy. A further increase in debt levels will ultimately lead to economic deterioration, an increase in systemic risk, as well as possible deflation.

“Therefore, at best QE2 can be nothing more than a short-term panacea, exacerbating the serious structural problems facing the United States.”

However, they point out that US Fed also faces huge risks if QE2 fails, and is relegated to “history’s dustbin of failed projects, along with QE1, cash for clunkers, tax credits for first-time home buyers”, and other numerous failed attempts to boost the economy with rebate cheques.

Ultimately, US politicians may decide that the US central bank needs to be given more direct instructions regarding the purchase of financial assets, which would result in the central bank forfeiting its independence.

“Congress might assume that QE1 and QE2 were unsuccessful because they were too small, not that they are fundamentally flawed concepts,” the authors note. “On such a path, monetary policy could then become a mere branch of fiscal policy — a road to economic perdition.”

This story first appeared on Business Spectator.

Peter Fray

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