The Effectiveness Of Quantitative Easing

by: Lok Sang Ho

Quite a few commentators think quantitative easing does more harm than good. Some believe that QE will only push up inflation, and will not help the real economy. They cite the experience of Japan as evidence for QE to be ineffective. They say that Japan has tried QE well before Bernanke did. And yet Japan's economy continues on its listless path, while the Nikkei has remained a tiny fraction of its previous high seen decades ago.

The fact is, QE certainly has been extremely effective, at least in America. It appeared not to work for Japan only because the Bank of Japan failed to suppress the excessive strength of the Yen. To be effective, QE has to have an effect on the key variables that affect behavior, and has to be in sufficient dosage so that it can at least offset any countervailing factors that may arise. As long as Japan's QE fails to reverse the Yen's economically nonsensical strength, the Japanese economy will not recover in a meaningful sense.

Actually, the signs are that Japan will be in the grip of a major crisis before very long!

Hurt by a strong Yen, economic weakness of trading partners, and now additional difficulties caused by the standoff with China over the Diaoyu/Senkaku Islands, Japanese enterprises are bleeding. Today Japan's sovereign debt to GDP ratio is well over 200%, but this had not raised an eyebrow because Japan's governing debt had mainly been absorbed by domestic enterprises. Foreign exposure is small and is also limited to very few countries, China included. But with Japan's enterprises suffering from a major shrinkage in earnings, their ability to take up any more debt from the Japanese government will be tested. Since it is unlikely that other countries will rise to take up any slack left by the domestic enterprises, Japan's financial crisis is not very far off.

While QE has not worked for Japan so far because the Bank of Japan had failed to reverse the Yen's rise, the Fed in America has effectively reduced borrowing costs for American borrowers.

The American standard 30 year mortgage rate has now fallen to a mere 3.36%, some 300 basis points from what it was in 2008-2009 at the height of the global financial tsunami. This has saved huge amounts for homeowners, many of whom have refinanced their loans to benefit from the much lower rates. These savings have unleashed huge purchasing power for many American households, lending support to retailers, automobile manufacturers, and have helped revive the housing market.

The ongoing recovery in the housing market is giving impetus to the construction sector, and is giving reprieve to banks and other financial institutions.

The stock market has now broken new 4 year highs. The unemployment rate has fallen below 8% for the first time in years, and is now much lower than the over 10% at the height of the global financial tsunami.

Quite a few think QE will bring inflation, even hyperinflation. But this perception is only based on the gigantic growth in the Fed's balance sheets. Yet the Fed's balance sheet is quite misleading. Although it has grown in a frightening fashion, money supply has not! As long as the private sector remains cautious in lending and borrowing, the increase in the monetary base will translate into an increase in the money supply in only a much subdued manner.

At some point I had thought that QE1 was enough, and that there should be no need for QE2. But developments in Europe had made QE2 and then even QE3 necessary. To be effective, QE has to be in sufficient dosage to offset any countervailing factors, as I have pointed out above. Americans are lucky to have a Fed that is pragmatic enough to understand this and that is not bound by dogmatic and unscientific beliefs.

An American economic recovery is important to the global economic recovery. So QE3 should be welcomed and not ridiculed.

The American recovery is facing still yet another countervailing factor in the form of the fiscal cliff. This is a direct result of partisan politics. How the fiscal cliff issue unfolds is now the big uncertainty.

It is hoped that the new government to be elected will command enough seats in both houses to deal with the fiscal cliff issue effectively. Otherwise the Fed will still have to act boldly.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.