Debate :Why more Quantitative Easing,a Manifesto for Economic Sense.

The impact of Quantitative Easing operations undertaken by Central Banks in the developed world is an intensely debated topic and has sharply polarised opinions across academia, financial markets and the popular media. However, as with the debate on austerity versus spending, the discussion tends to get clouded by firmly held ideological biases rather than focusing on empirical based arguments. With that aim in mind, below is the summary of recent note

By Roger Farmer, head of the economics department at UCLA, which argues why central banks should do a lot more to reduce unemployment and boost economic growth:

-In a series of recent academic work , Professor Farmer has argued that there is a stable, and causal, relationship between the stock market and the unemployment rate. And that the stock market crash of 2008, triggered by a collapse in housing prices, caused the Great Recession, and therefore the Fed can do a lot more to lower the unemployment rate by impacting the stock market..

-The chart below illustrates that in normal times the Fed's balance sheet consists mainly of treasury securities, and that after the Lehman shock of 2008 and the ensuing freefall of the stock market, its balance sheet went from $800BN to over $2 trillion in the space of a month, as it engaged in a variety of lending programmes.

-As the chart also clearly shows, the stock market rally began in March 2009 when the Fed began purchasing mortgage securities, and began to fall once the QE1 programme ended a year later. The market then began its ascent In August 2010 when the Fed announced QE2 at its annual Jackson Hole conference.

-Fed policy not only influences markets, it has a big impact on the average citizen as all forms of wealth tend to move up and down together. A person's wealth is tied-up in his future earnings,  and when the stock  market plummets the prospects of the average worker decline as well. His research has shown that when the stock market rises, unemployment falls and when the stock market crashes a recession ensues.

-Suppose an economist working in the 1970s was trying to predict the unemployment rate three months forward by looking just at the average unemployment rate and the real value of the stock market in the previous two quarters,  his predictions would have been very accurate in that era as well as the more recent era.
-The  observation  that the value of the stock market precedes changes in the unemployment rate does not imply a causal relationship. However, this has been proven by his recent academic work based on data since 1929.    

-Market are moved by sentiment, but these movements have a big impact on our lives through the job market  - as plunges in  financial wealth can lead to devastating  job losses.  The Fed can do a lot more.

An interesting  empirical argument which  illustrates  that central bank actions to expand balance sheets  can positively impact the  stock market as well as the real economy. While an environment of deleveraging and zero short-term interest rates can limit the full impact of monetary policy, it is all the more necessary to take aggressive monetary action, particularly given that governments across the developed world are constrained by their  inability to do more on the fiscal front. Aggressive balance sheet expansion lowers  the real interest rate (by increasing inflationary expectations) which is a powerful tool to boost aggregate demand and increase investment spending.  It is therefore inevitable that the Fed and the ECB will have to do a lot more to buoy the stock markets and the economy, as the process of deleveraging and fiscal constraint continues.

The European Summit  marked an important  step in the long-term  resolution of the European  crisis by breaking the "vicious circle between sovereigns and the banks" by  allowing direct recapitalisation of the banks by the ESM. However, the devil is in the details and we can expect renewed bouts of nervousness in the weeks and months ahead. As Gavyn Davies points out in the FT, the ESM has been asked to do more without the addition of funds (which are currently inadequate to fund Spain and Italy's financing needs  over the next two years) and many details are obscure. Use the dips to add to exposure to risk assets, as the fat tail risk of a Euro break-up  has receded significantly.

Lastly, Professors Krugman (Princeton) and Layard (LSE) have brought out an important "Manifesto for Economic Sense" which summarises the faulty ideas currently prevalent in policy responses to the crisis which started four years ago, and have  directly led to a continued state of depressed economies in the developed world.  These ideas were also widespread in the 1930s,  causing  the Great Depression,  but were eventually rejected leading to a long period of economic prosperity.  The purpose of the manifesto in to develop better evidence-based policies and people who agree with its arguments can support this by registering their agreement at"The whole world suffers more when men and women are silent about what they know is wrong".

About author

Make it happen !!


Leave a Reply