Given the significance of last week’s announcement of QE3 from Fed Chairman Ben Bernanke, I decided to repost the blog’s discussion of QE3 from our series on quantitative easing last fall. If you would like more information on historical uses of quantitative easing, or the past record of its implementation in the United States, I encourage you to look back at our five part discussion from November of 2011. While the economy has certainly changed since our series was introduced, here are the predictions of the implementation of QE3 and its possible effects that we made:
The implications of QEIII:
Since the conclusion of QE2, speculation has begun to intensify surrounding the potential of a third round of quantitative easing, as Chairman Bernanke said that the central bank was prepared to ease further “if economic growth and inflation falter again.” In August, Goldman Sachs economists released a report predicting a third round of easing, and in a CNBC poll from the same month, 46 percent of economists surveyed stated they believe that QE3 will occur, versus only 37 percent disagreeing. Yet while the specifics of the plan remain ambiguous, critics of such a move suggest that the consequences of such an action will have a similar effect to that of QE2, with unemployment remaining high and GDP growth low. Whereas deflation was a primary concern when considering QE2, it now appears that inflation is a realistic possibility, as the CPI has increased 3.6 percent over the past year, compared with a rate of 1.1 percent the year before. Further damaging the hypothetical effect of QE3 is political and economic turmoil both domestically and abroad. The S&P downgrade of U.S. debt, as well as the debt crisis in Europe, has added greatly to an already elevated level of uncertainty within the global marketplace. As uncertainty was a major factor in limiting the impact of QE2, firms and individual consumers seem to be more nervous than ever, making them less likely to spend or invest due to the difficulty of measuring the riskiness of their future cash flows. “Monetary policy should help economic activity, but right now it’s just not working,” states Guy LeBas of Janny Montgomery Scott, “banks are taking that cash and just re-depositing it with the Fed. It’s not that banks don’t want to loan money, it’s because they can’t. There’s very little loan demand out there from consumers and businesses”.
Another cause for concern when considering the ramifications of a third round of quantitative easing is the impact it may have on the United States image and faith in the dollar abroad. When word of QE2 first broke, many countries around the globe were already in strong opposition given the programs devaluing effect on the dollar. A devalued dollar does not only damage emerging economies, however, as many developed nations have called the Fed’s weak dollar policies currency manipulation which gives the country an unfair advantage in exports. Such international hostility can not only undermine economic recovery efforts, but also threaten long term prospects for the United States as a global economic leader. It is not unfeasible to believe that should the U.S. continue to antagonize countries abroad by weakening the dollar, the world’s leading economies may ultimately drop the dollar as the world’s reserve currency. According to a recent poll of central bank managers, a majority believes that the U.S. will lose this privilege within the next 25 years and be replaced by a basket of currencies. China has already taken action to negotiate deals without the use of dollars, “China supported a Russian proposal to start direct trading using the yuan and the ruble rather than pricing their trade or taking payment in U.S. dollars or other foreign currencies. China then negotiated a similar deal with Brazil.” Many of those who believe a shift in the reserve currency is coming point directly to the Federal Reserve’s expanded balance sheet and inflationary actions as exacerbating a trend away from the dollar as reserve currency, especially as growing economic powers such as China and Russia hold increasing amounts of U.S. debt.
The results of a shift from using the dollar as the world’s reserve currency in favor of a basket of currencies would be, by all indications, catastrophic for the United States economy. The United States has been the world’s reserve currency since the Bretton Woods Conference in 1944, when the world’s leading economies established a system where international currencies tied their monetary policy to an exchange rate with the dollar. Since then, the dollar has maintained this status due to the ease and tools through which foreign countries could convert their currencies into dollars as, being as reserve currency, the dollar is held in large amounts by governments and other institutions around the world. Another benefit of holding reserve currency status is that many commodity prices, such as oil and gold, are currently priced in terms of dollars, giving U.S. consumers the advantage of not incurring the cost and time of converting currencies to purchase such commodities. If dollar reserve status was to shift, prices would inflate drastically in the U.S., hiking up energy costs for both firms and individuals. General inflation within the economy stands to escalate as well given the drastic increase in dollar supply during the Fed’s first two rounds of quantitative easing.
Should such inflation occur, the Fed could hypothetically sell bonds on the open market to lower money supply, yet with the loss of reserve currency status, demand for U.S. bonds will drop drastically and the cost of financing debt will skyrocket. In terms of competitiveness for American businesses, the effect of losing reserve status could be severely debilitating. Since many international contracts are valued in dollars, American firms benefit from a competitive ease over international competition similar to the one held with commodities. Should the dollar lose reserve status, these advantages would immediately disappear, and while a weaker dollar generally makes American exports more attractive due to their relative cheapness compared to foreign prices, firms would be operating on much thinner margins due to the increased cost of converting currencies and faced with the threat of increased federal taxes as the deficit grows. Ultimately, the loss of reserve currency status for the greenback would severely undermine U.S. economic prospects by depressing consumption and investment levels, weakening U.S. competitiveness in the international market, and rendering monetary actions typically taken by the Federal Reserve to inject liquidity into the market less in an economic downturn less effective and much more expensive to finance, thus further increasing the federal deficit.
 See Waki.
 Handley, Meg. “Could QE3 Help the Economy?” Business News and Financial News. US News and World Report, 11 Aug. 2011. Web. 5 Nov. 2011.
 Washington, Jason Lange. “Federal Reserve Might Not Undertake QE3, And It Might Not Help If They Do.” Breaking News and Opinion on The Huffington Post. The Huffington Post, 13 Aug. 2011. Web. 9 Nov. 2011.
 See Handley.
 See Handley.
 See Washington.
 Furchy, Jack. “Dollar Seen Losing Global Reserve Status.” Financial Times. 27 June 2011. Web. 2 Nov. 2011.
 Hudson, Michael. “U.S. Quantitative Easing Is Fracturing the Global Economy.” The Market Oracle. 1 Nov. 2010. Web. 7 Nov. 2011.
 “The Rise of Bretton Woods | The Economist.” The Economist. 23 Oct. 2008. Web. 8 Nov. 2011.