Velk on QE2

Tom Velk from McGill’s North American studies observed that the market is not responding to the Federal Reserve’s QE2 programme. In the same commentary Velk also provided the underlying principles of the financial market as we understand it and argued that because prospects of growth are anticipated to be grim and that the counter-recession programmes have hampered the perceived solvency of most countries, the markets simply won’t budge.

(For readers with no economics background, Quantitative Easing is (typically) the purchasing of government securities to lower the interests they pay by using money printed by the central bank, as empowered in the law of its creation. The purpose is to create additional supply of money so that commercial banks will lend them out and hopefully, spur growth to bring a country out of a recession. There are a few psychological factors that should in theory, spur investments and spending in an economy.
1. When short-term interest rates are low and firms are not responding, lowering the yield of long-term interest rates by purchasing government securities (or other financial instruments) will create more money in the economy so that no one has the incentive to hoard it as a store of value.
2. If the economy expects that there are prospects for growth, borrowing when it is cheap right now might pay off in the future when the economy recovers.
3. A slightly more “evil” twist to see this is that when investors think that inflation(rise in price of goods) that is about to accompany growth when the economy recovers will decrease the value of their assets, they will be be more inclined to invest in assets; or in the case of firms, instead of holding the money they have as part of their capital, will invest it instead. Either way, because of the fear that their assets might lose value, these individuals or firms will spend right now, thus collectively veering the economy to recovery.)
For a take on QE in combating a liquidity trap that mired us in this depression, I recommend Paul Krugman’s Return of Depression Economics. Alternatively you can read this post from some lousy wannabe.
An important caveat: The success of any round of QE is contingent of the Federal Reserve and by extension, the government’s ability to persuade the market that the recession is but a glitch and prospects for future growth is solid. Velk’s commentary is arguing that as of now, the Fed and the government has not succeeded in doing this thus far).

Instead of piling their faith on the government programmes and the central bank, as Velk argued, investors are flocking to a more “tangible” store of value in commodities like oil, gold etc. The gold-bug camp argues that because investors are jitterish about the run-away inflation that seems plausible when the economy recovers and that the Federal Reserve might not be able to rein-in the excess of supply of money, the price of gold is skyrocketing.(For non-economics readers again, what we mean by this is that investors are worried that the excess supply of money will make their money worthless because inflation caused by the rise of the price of goods will take away the value of their money. Think about the stories your parents told you about how Char Mee Hoon used to cost 5 cents.An illustration can be found here, linked from Greg Mankiw’s blog). In this I share the view of  economists who disagreed. Scott Sumner for instance, argued that the increasing price of gold is not due to the fear of inflation afflicting North America, but rather the increase in demand for gold from China, where the people are hedging against the inflation in an overheated market. (Scott Sumner’s post was made accessible from Hisham’s blog).

It is in this that I think using the soaring price of gold to argue that investors are spooked by inflation overstates the case against QE2. I admit however, the credibility of governments and central banks are under siege. What we need right now is not the fear of inflation, but rather inflation to hurtle us out of this mess. The key in achieving that while assuring the market that it will be placed under control would require the satisfaction of these conditions:
a) That policy makers explicitly target an inflation rate.
b) To provide a stable macro-economic conditions for investors.
c) Enact policies (tax cuts, government spending etc) to boost real income and create a feedback loop of recovery.

In all sense the economy is analogous to a game of music chair. If everyone pretends that the music hasn’t stopped and keeps on passing the parcel, the game goes on. What we need then is to get all these players to continue to pass on the parcels by making them believe that the music is still going on, regardless of what it may be objectively. When the music is played back, we’d all still be trudging along.

On what I think about austerity packages right now, I quote Keynes ” In the long run we’re all dead.”


2 Responses to Velk on QE2

  1. It seems to me that many of your generation are simply "opting out" of the market economy, in one way or another. Many seem to feel that they are simply being manipulated by forces beyond their control. They response appears to be to simply walk away. What is your take on this?

  2. GoatKY says:

    To me it has never been a question of choosing either one of a market system or a command system, but the degree of inclination to any one of them. I definitely empathise with the frustration leading people to walk away, but I don't think we have a strong case for completely abandoning the system.Instead what is needed is how to repair the flawed system. As a moderate liberal I might hold the view that spreading the wealth around and giving people who had their opportunities deprived a chance would be best, but naturally in the normative debate on spreading the wealth my conservative counterpart will disagree. The silver lining is in that a lot of moderate conservatives are willing to look beyond the superficial nature of the arguments over contrasting ideals and look at reality as it is. We will not object that Sidney Crosby, George Clooney and Steve Jobs get paid more because their contributions to society in a way is greater. What we find equally repulsive is that the people gaming the system by creating money out of thin air and playing their music chairs with their derivatives are allowed to walk away with their golden parachute with the mess they have created, and everybody else has to pay the price of cleaning it up. This has led to some serious soul searching and a lot of us have begun to question the utilitarian framework built into our welfare system. Some are arguing for a just deserts theory, that people should be compensated equally to their contribution to society, and that also extends to aiding the poor so that they have a chance to live up to the potential of their contribution. By itself the market is supposed to be the manifestation of our collective actions and beyond manipulation. Some got away with gaming the system by virtue of creating an artificial pyramid and installing themselves on top with the inequalities they create. On campus we do have some discourses going on about the same thing.The marxist groups are issuing a clarion call for a total abandonment of the system and live up to Marxism. Some of us are working on fixing it, and I am encouraged to see that some business students take this seriously. Shaping Tomorrow's Organisational Practices for example had a Green Business Week and we had the chance to hear from people from Deloitte on the growing field of Green Consulting. Walmart and a lot of those big boys are really working on trying to be good environmentally (the most credit I can give to them is on this front only, they ought to improve on some business practices). I also went to a forum hosted by Bombardier and they are working very hard in cutting their carbon emissions and recycling the trains at the end of their service. PS: The contract fiasco reminds me of home though.

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