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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.”[1]  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.[2][3]  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.[4]  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”.[5]

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.[6]  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.[7]  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.”[8]  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.[9]  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.

[1] See Waki.

[2] Handley, Meg. “Could QE3 Help the Economy?” Business News and Financial News. US News and World Report, 11 Aug. 2011. Web. 5 Nov. 2011.

[3] 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.

[4] See Handley.

[5] See Handley.

[6] See Washington.

[7] Furchy, Jack. “Dollar Seen Losing Global Reserve Status.” Financial Times. 27 June 2011. Web. 2 Nov. 2011.

[8] Hudson, Michael. “U.S. Quantitative Easing Is Fracturing the Global Economy.” The Market Oracle. 1 Nov. 2010. Web. 7 Nov. 2011.

[9] “The Rise of Bretton Woods | The Economist.” The Economist. 23 Oct. 2008. Web. 8 Nov. 2011.


The Wall Street Journal discusses four developments to watch at the two-day Fed meeting this week.  While the main story is of course whether or not Chairman Bernanke will announce a third round of quantitative easing, a move much of the market expects, the article points to three other points to watch.  Specifically, what the Fed will do with the Operation Twist program that it has recently extended, how they will handle communication about their actions as the economic downturn continues, and finally, whether or not they will lower the interest rate on bank reserves which currently rests at 0.25%.

The Operation Twist decision will be especially interesting to watch, as this will determine just how much of a new bond and mortgage-backed security purchasing program will be funded with newly printed money versus the short-term bond sales which currently fund the program.

Informative and intriguing read from ABC News Chief Foreign Correspondent Richard Engel on the current state of the “Arab Spring” and the Middle East as a whole.  The article does a great job of providing both the history of the geographic and demographic trends of the Middle East, as well as analyzing the events that have occurred since America went into Iraq, and through the current turmoil in Syria.  Engel addresses how the rise of the Shiites in Iraq following the toppling of the Sunni-led Hussein regime has sparked furor within the region which is occupied by a Sunni majority.  Engel asserts that Al-Qaida, a Sunni insurgent group, has used this to gain support within the region, and has furthered their agenda by providing assistance to the Sunni rebels who now hope to overthrow the Shiite-led Assad regime in Syria.

The article provides a comprehensive look at the region as a whole, and whether or not you agree with Engel’s conclusions, the background and history that it provides is invaluable to understanding the current state of affairs in the Middle East.

With the Democratic National Convention beginning this week in Charlotte, and with the President’s keynote speech on the docket for Thursday night, the most recent edition of the Economist considers what lies ahead should the President be re-elected.  The publication highlotes both the strengths of the first four years of the Obama administration, as well as the weaknesses, particularly the persistently high unemployment and the President’s weakened approval rating.  The Economist notes that even with a re-election, the President will continue to find staunch opposition from the Republican House majority, a stubbornness that could increase in light of the increasingly contentious political ads between the two parties.  The magazine contends that in a second term:

A tempting option will be to galvanise his party base, with talk of more health reform and threats of higher taxes on business and the rich. Rather than redesigning government, he could suck up to the public-sector unions by promising that jobs will not be cut. Rather than cutting entitlement programmes, he could reassure the elderly that America can actually afford them.

Such an approach is largely feasible given the current state of American politics, though worrisome given the fiscal status quo.  Without a significant reformation, in whatever form that may be, it appears that stagnation will continue to plague the U.S. economy and government.  Such potential makes this week’s DNC particularly intriguing.  Thursday’s address in Charlotte could go a long way in charting the future path of the United States, though unfortunately as the Economist considers, much of the similar rhetoric from four years ago has not yet come to fruition.

Recently, former Massachusetts Governor Mitt Romney’s proposed tax plan has been receiving a great deal of coverage and criticism, especially in the wake of the Tax Policy Center’s assertion that it was “mathematically impossible”.  Washington Post writer Ezra Klein covers the TPC’s analysis in this Bloomberg op-ed, asserting that to implementing the Romney tax plan in a way that would not drastically reduce federal tax revenue would inevitably result in an increase in taxes on the middle class and a reduction in the progressivity of our tax code.

In response to such criticisms, former Reagan economic and current Romney adviser Martin Feldstein disputes the TPC simulation as one which is “inevitably speculative” since it attempts to model taxable income at all levels in 2015.  In his analysis of the plan, Feldstein instead measures the amount of revenue that would be lost by the 20% marginal tax rate reduction using IRS data from 2009, and describes ways in which this reduction can be reconciled.

With regards to the principle that a reduction in rates can in fact increase the taxable income of an individual through incentivizing more income generating activities such as work, Feldstein asserts that generally a 10% reduction in the tax rate of an individual results in a 5% increase in their taxable income level.  This, combined with Feldstein’s proposed measures to broaden the tax base eliminating some, but not all exceptions and expenditures, could easily reconcile the gap in revenue cause by the reduction in rates, and in fact raise overall revenue according to Feldstein’s analysis.

From Alberto Alesina, Carlo Favero, and Francesco Giavazzi, through Greg Mankiw’s blog, new research considers the effect of fiscal corrections on output losses, attempting to determine whether spending and tax based fiscal reforms have a significantly different effect on future output from one another.  The paper concludes that:

“Allowing for cross country heterogeneity in the style of fiscal adjustments delivers estimates which are much more precise than those obtained studying the effects of individual fiscal shocks within an aggregate cross country analysis. The key result is that while expenditure-based adjustments are not recessionary, tax-based ones create deep and long lasting recessions.”

Additionally that:

“The differences between the two types of adjustments appears not to be explained by a different response of monetary policy.”

Though such research cannot fully explain or diagnose an ideal prescription for a country’s fiscal problems, it does shed interesting light on the fiscal debate.  When political rhetoric and debate is introduced to the fiscal policy conversation, the solution becomes even more convoluted.  If spending cuts cause economic difficulties, even if only in the short run, politicians approaching election years may be more reluctant to adopt such cuts for fear of angering constituents.  Such potential conflict of interest increases the difficulty in instituting effect reforms consistent with empirical data and evidence.

In a Tuesday op-ed piece, Harvard economics professor Edward Glaeser considers the implications of the Affordable Care Act’s individual mandate in the context of state and federal mandates.  Rather than addressing the legal intricacies of the debate, Glaeser considers the economics of alternatives to the ACA which could reconcile pieces of the nation’s healthcare problems without increasing federal power in the marketplace.

With regards to the question of how to solve the “free-rider” problem currently in place, of insured patients bearing the brunt of uninsured patients’ healthcare costs, Glaeser proposes a tax for the externality.  In his contention, by imposing a tax of roughly $170 annually on the 50 million uninsured Americans, the burden of cost would no longer be on the insured for their healthcare, and would serve as motivation for the uninsured to purchase coverage.  In this way, the government could incentivize the purchase of healthcare amongst the uninsured without directly mandating it.

Glaeser points out that he does not, in fact, oppose all forms of individual mandates, but believes that they should be legislated on the state level.  His argument follows two main points: first, with regards to costs, the balanced budget provision which all states, except VT, have in place, would ensure that healthcare costs would be a primary focus of legislators required to do so by law.  While lobbying dollars from healthcare and pharmaceutical companies may threaten to increase costs in Washington and further the federal deficit, such increases would be much less tolerable on the state level given the legal requirements imposed on the state legislatures.  Secondly, Glaeser contends that by allowing mandates and healthcare to be controlled on the state level, such as in Massachusetts, legislators will be better able to structure and adapt the system to the citizens of their state.  If a citizen is unhappy with the healthcare system in their state, they could hypothetically easily move to another.  By being legally bound to remain diligent about healthcare costs, and more directly accountable to the systemic results, state legislators would be able to offer patients better and cheaper healthcare than federal legislators could.

A quality editorial from Bloomberg on Wednesday addresses the fallacious arguments of the Federal Reserve’s Congressional critics.  Since the Fed’s announcement yesterday that they would continue their “Operation Twist” (explained here) program in attempt to put further downward pressure on borrowing costs and increase credit, critics of Chairman Ben Bernanke, such as Jim DeMint of South Carolina, have chastised him for enabling further federal deficit spending.  While, as the editorial points out, by lowering long-term Treasury bond yields the Fed is indeed allowing deficit borrowing to be done at a cheaper rate, pointing the finger at Bernanke for the growing deficit does little to encourage a long-term solution.  Ideas, such as limiting the size of the Fed’s balance sheet, do little to nothing in terms of solving our deficit problem, but would do an effective job at dulling one of the only remaining tools the government has to battle the stagnant economy.

Truly, the only long-term solution to our national spending profligacy must come through the Congress.  While last year’s attempt at resolving the issue failed, no action outside of a Congressional deficit reduction agreement has the ability to make a substantial dent in the growing national deficit.  Though the contentiousness of last summer’s negotiations make such an agreement seem politically infeasible, petty attempts at redirecting national criticism and blame to the Fed and other sources irresponsibly circumvents the inescapable solution, no matter how politically difficult it may be.

Investor George Soros recently gave a speech regarding economic markets theory and how they tie into the future of Europe at the Festival of Economics in Trento, Italy.  The speech addresses some of the principal holes which Soros finds in common market theory, including the idea of perfect information amongst market participants.  He equates the Euro crisis to “like a bubble. In the boom phase the EU was what the psychoanalyst David Tuckett calls a “fantastic object” – unreal but immensely attractive.”  His incorporation of the political atmosphere in Europe into his prediction leads him to believe that the Euro has about a “three-month window” to resolve the issues which afflict the Eurozone.

Soros postures that the key to a continued Euro will lie, like many believe, with the Germans.  He finds that “it would require an extraordinary effort by the German government to convince the German public to embrace the extraordinary measures that would be necessary to reverse the current trend. And they have only a three months’ window in which to do it.”  Soros notes that over the past year, many countries have begun reordering their debt along national lines, and have begun for the first time, openly discussing the possibility of a breakup that seemed impossible just 2 years ago.  The results of the June 17th Greek elections, along with the many election cycles coming in the fall, will largely indicate the willingness of Europeans to sacrifice national sovereignty for the common currency.  Without Germany leading the way, Soros finds the Euro has little chance of surviving.

Soros’ discussion does an effective job of covering much of the continuing European issues and offers an educated and detailed prediction at where the Euro is headed.  It is a speech which I highly recommend reading.

A short article published in The Atlantic yesterday suggests that, based on past decision-making and Federal Reserve press releases, the likelihood that a third round of quantitative easing will occur is relatively low.  The graph below shows the relationship between the Fed’s balance sheet (blue) and core inflation (red).

Core inflation dropped significantly in 2009, and the Fed subsequently expanded its balance sheet with QE1 to combat the specter of deflation.  It again engaged in a quantitative easing program, QE2, in late 2010 when the core inflation continued to drop.  Now, however, inflation seems stabilized around the 2 percent level.  According to the Fed:

“A couple of members indicated that the initiation of additional stimulus could become necessary if the economy lost momentum or if inflation seemed likely to remain below its mandate-consistent rate of 2 percent over the medium run.”

It appears that, unless inflation drops below this 2 percent level for a prolonged period, a third round quantitative easing is unlikely.


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